CORPORATIONS SUPPLEMENTARY READINGS

PART ONE

Professor Jennifer Arlen NYU Law School

Fall Term 2013

@ Jennifer Arlen 2013

INTRODUCTORY MATERIALS
In order to understand the first cases it is useful to have some background information on the basic structure of corporations and on agency law. For some of you this will be new material; for others it is review. I have tried to keep this very short. Those of you who need more information should consult Klein and Coffee. PRINCIPAL/AGENT: CONTRACTUAL SETTING The central players in principal/agent relationship are the principal(P), the agent (A) (or alleged agent) and the third party (T). Most of the cases we will focus on involve contractual liability of principals for acts of agents. We spend very little time on tort. Generally, A has entered into a contract with T, some problem has arisen and the question is who is liable on the contract: (i) is A. liable? (ii) is P. liable?, and/or (iii) is T. bound. The answer to these questions depends on whether A actually was an agent of the principal and if so, what type of agent. The basic rule is that an agent is someone who by mutual assent acts on behalf of the other and subject to the other's control The study of agency law focuses in part on how do we know when there has been such assent. Is it when the principal actually gives it; when the agent believes P. has established this relationship; when a third party so believes: or in some other situation? Agency law has developed five categories of agency which address many of these different possibilities: actual authority (express or implied); apparent authority; ratification; and inherent agency power. Actual agency is the most straightforward. The test is simple: did the A. reasonably believe, based on the P's conduct/manifestations, that the A. was acting on P's behalf and subject to his control. This manifestation by P. may be express or implied. It is express if P. expressly directs A. to enter into a particular contract on P's behalf. It can be implied in a number of situations. The most common is where P. hires A. to perform a job -- for example, to be President of the firm -- and an inherent part of that job is the power to hire and fire employees. If A. has actual authority, P. is bound on the contract to the third party. Moreover, P. cannot seek indemnification from A. Apparent Authority: A. has apparent authority if, based on P's conduct, a reasonable person in the third party's position would belief that A. is P's agent: that A. is acting on P's behalf and subject to P's control. P's conduct may be nothing 1

more than giving A. a job title that normally carries with it the authority to enter into the contract in question and not informing the third party that in fact A. has no such authority. If A. has apparent authority, P is liable to the third party but can get indemnification from A (unless of course A also had actual authority). Ratification: If initially A. entered into a contract purportedly on P's behalf, but without actual or apparent authority, and P. subsequently decides to adopt the contract, then P. is bound, as is the third party. Inherent Agency Power: This is very messy. This theory encompasses respondeat superior (the doctrine that holds P's liable for A's torts even if the A's negligence was against express instructions). It also holds P's responsible for some acts of agents which, while unauthorized, are nonetheless quite close to (or incidental to) that which they are authorized to do. CORPORATIONS Because our early cases involve corporations, it is important to understand some basic facts about corporations. A corporation is a business organization which is owned by shareholders (also called equity holders) but managed by professional managers (who also may own shares). The ultimate locus of managerial power is the Board of Directors, which makes the big decisions governing the firm. Day-to-day management is in the hands of the officers, such as the Chief Executive Officer, the President, and the Chief Financial Officer. Officers may also sit on the board. Shareholders determine who shall be on the Board at each annual meeting; the general rule is voting for the board is based on how many shares you have (one share/one vote). Generally, the Board selects the officers. Corporations are treated as legal persons. A corporation can enter into a contract and sue and be sued. A corporations also can held to be a "principal," liable for the acts of its agents.

QUESTIONS ON CARGILL (Read the Restatement of Agency sections list in syllabus before answering) 1. What is the basis of the farmers' claims that Cargill is liable to them for the contracts executed by Warren? On appeal is the farmers claim predicated on a showing of actual authority or apparent authority? What is the difference? 2. The court says that in order for an agency relationship to arise the principal must consent? Did Cargill want to create agency relationship with Warren? If so, why did Cargill structure the arrangement as two separate arrangements: a financing agreement plus a right of first refusal on the grain? If not, then how can Cargill be liable if it did not want to be a principal? To what must it consent? 3. What is the holding of the court? At what point in time did the agency relationship arise? What factors did the court consider? Are they really all relevant? What type of control is at issue? Did Cargill exert day-to-day control over Warren? What facts suggest it did or didn't. What facts suggest Cargill may have had more control than it might at first appear? 4. What relationship did Cargill say the two parties had? Examine the court's reasoning for rejecting this argument. Is the court right? In examining the buyerseller issue, what price did Warren sell grain to Cargill at? Why might this matter? reexamine the definition of an agency relationship. Is there a weakness in the court's analysis? 5. Why did Cargill keep Warren alive? Why do we care? 6. Given this holding, who can recover from Cargill? Specifically, can all farmers who sold grain to Warren during this period recover, even if they did not know that Cargill is in the picture? 7. Given the holding as to the nature of the agency relationship, can Cargill recover from Warren? Do you think this outcome is correct? 8. Given this holding, would Warren be directly liable to the farmers should it turn out to have money. Examine the Restatement 3rd of Agency.

Dan LIND, Appellant v. SCHENLEY INDUSTRIES INC. United States Court of Appeals Third Circuit. Decided April 6, 1960. Before BIGGS, Chief Judge, and GOODRICH, McLAUGHLIN, KALODNER, STALEY, HASTIE and FORMAN, Circuit Judges. BIGGS, Chief Judge. This is a diversity case. Lind, the plaintiff-appellant, sued Park & Tilford Distiller's Corp.,1 the defendant-appellee, for compensation that he asserts is due him by virtue of a contract expressed by a written memorandum supplemented by oral conversations as set out hereinafter. Lind also sued for certain expenses he incurred when moving from New Jersey to New York when his position as New Jersey State Manager of Park & Tilford terminated on January 31, 1957. The evidence, including Lind's own testimony, taking the inferences most favorable to Lind, shows the following. Lind had been employed for some years by Park & Tilford. In July 1950, Lind was informed by Herrfeldt, then Park & Tilford's vice-president and general salesmanager, that he would be appointed assistant to Kaufman, Park & Tilford's sales-manager for metropolitan New York. Herrfeldt told Lind to see Kaufman to ascertain what his new duties and his salary would be. Lind embarked on his new duties with Kaufman and was informed in October 1950, that some 'raises' had come through and that Lind should get official word from his 'boss', Kaufman. Subsequently, Lind received a communication, dated April 19, 1951, signed by Kaufman, informing Lind that he would assume the title of 'District Manager'. The letter went on to state: 'I wish to inform you of the fact that you have as much responsibility as a State Manager and that you should consider yourself to be of the same status.' The latter concluded with the statement: 'An incentive plan is being worked out so that you will not only be responsible for increased sales in your district, but will benefit substantially in monetary way.' The other two district managers under Kaufman received similar memoranda. Lind assumed his duties as district sales manager for metropolitan New York. During the weeks following Lind's new appointment, Lind inquired of Kaufman frequently what his remuneration would be under the incentive plan referred to in the letter of April 19, 1951, and was informed that details were being worked out. In July 1951, Kaufman informed Lind that he was to received informed Lind that he was to receive get a 1% Commission of the sales of the men under him. This was an oral communication and was completely corroborated by Mrs. Kennan, Kaufman's former secretary, who was present. On subsequent occasions Lind was assured by Kaufman that he would get his money. Lind was also informed by Herrfeldt in the autumn of 1952 that he would get a 1% Commission of the sales of the men under him. Early in 1955, Lind negotiated with Brown, then president of Park & Tilford, for the sale of Park & Tilford's New Jersey Wholesale House, and Brown agreed to apply the money owed to Lind by reason of the 1% Commission against the value of the goodwill of the Wholesale House. The proposed sale of the New Jersey Wholesale House was not consummated.
Park & Tilford Distiller's Corp. was merged into Schenley Industries, Inc., a Delaware corporation, before the commencement of this action, with Schenlay assuming all of Park & Tilford's obligations. Schenley was substituted in this action on March 31, 1958, by order of Judge Wortendyke.
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Notice to produce various records of Lind's employment was served on Park & Tilford but one slip dealing with Lind's appointment as district manager was not produced and is presumed to have been lost. The evidence was conflicting as to the character of the 'incentive compensation' to be offered Lind in connection with his services as a district manager. Herrfeldt designated the incentive an 'added incentive plan with a percentage arrangement'. Kaufman characterized the plan as 'bonuses and contests'. Weiner, Park & Tilford's Secretary, said that the incentive was a 'pension plan.' Kaufman testified, however, that the pension plan had nothing to do with the bonus incentive he referred to. The record also shows that Lind commenced his employment with Park & Tilford in 1941, that from 1942 to 1950 he worked on a commission basis, that on August 31, 1950, he became an assistant sales manager for the New York metropolitan area at $125 a week, which was raised to $150 a week on October 1, 1950, plus certain allowances. After Lind became district manager on April 19, 1951, he continued to receive the same salary of $150 a week but this was increased to $175 in January 1952. On February 1, 1952, Lind was transferred from New York to New Jersey to become state manager of Park & Tilford's business in New Jersey. He retained that position until January 31, 1957, when he was transferred back to New York. Park & Tilford moved for but was denied a directed verdict at the close of all the evidence under Rule 50, Fed.R.Civ.Proc.,. However, the court below invoked Rule 50(b) and submitted the case to the jury subject to a later determination of the legal questions raised by Park & Tilford's motion to dismiss. The court then requested the jury to answer the following five questions: '1. Did Kaufman offer plaintiff one percent of gross sales effected by the salesmen under plaintiff?' '2. If the answer to question 1 is yes, when was plaintiff to commence such commissions?' '3. If the answer to question 1 is yes, when was the commission arrangement to terminate?' '4. Did defendant cause the plaintiff to believe that Kaufman had authority to make the offer to plaintiff referred to in question 1?' '5. Was plaintiff justified in presuming that Kaufman had the authority to make the offer?' The answers provided by the jury amounted to a determination that Kaufman did offer Lind a 1% Commission on the gross sales of the men under him; that the agreement commenced April 19, 1951; that the agreement terminated February 15, 1952, the date of Lind's transfer to New Jersey; that Park & Tilford did cause Lind to believe that Kaufman had authority to offer him the one percent commission; and that Lind was justified in assuming that Kaufman had the authority to make the offer. In addition, the jury awarded Lind $353 as reimbursement for moving expenses incurred by him at the termination of his position as New Jersey State Manager. The jury did not give a dollar award for the commission deemed owing but the court 'molded' the verdict in accordance with the jury's findings and judgment was rendered in favor of Lind against Schenley for $36,953.10 plus interest for the commission and $353.00 for the moving expenses. However, the judgment was nullified by the court's decision to enter a verdict for the defendant under Rule 50(b) in accordance with Schenley's first motion. The court, also under Rule 50(b), granted a new trial in the event that the judgment in favor of the defendant was subsequently reversed. The Judgment for Defendant The decision to reverse the verdict for Lind with respect to the 1% Commission was based on two alternative grounds. First, the court found that Lind had failed to prove a case of
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apparent authority in that the evidence did not disclose that Park & Tilford acted in such a manner as to induce Lind to believe that Kaufman had been authorized to offer him the 1% Commission. Also the court concluded that the issues of 'actual' and 'implied' authority had somehow been eliminated from the case. Second, the court reasoned, that even if the jury could find apparent authority, the alleged contract was not sufficiently definite nor specific to be enforceable against Park & Tilford. The trial judge rejected a contention by Park & Tilford that a document signed by Lind on January 31, 1957, upon receiving his last pay check as New Jersey State Manager, should be construed as a release of his claims for commissions. *** The jury clearly found that Kaufman had apparent agency power to offer Lind the 1% Commission and this verdict may be reversed only if there is no substantial evidence which could support the verdict. The problems of 'authority' are probably the most difficult in that segment of law loosely termed, 'Agency'. Two main classifications of authority are generally recognized, 'actual authority', and 'apparent authority'. The term 'implied authority' is often seen but most authorities consider 'implied authority' to be merely a sub-group of 'actual' authority. *** 'Actual authority' means, as the words connote, authority that the principal, expressly or implicitly, gave the agent. 'Apparent authority' arises when a principal acts in such a manner as to convey the impression to a third party that an agent has certain powers which he may or may not actually possess. 'Implied authority' has been variously defined. It has been held to be actual authority given implicitly by a principal to his agent. Another definition of 'implied authority' is that it is a kind of authority arising solely from the designation by the principal of a kind of agent who ordinarily possesses certain powers. It is this concept that is called 'inherent authority' by the Restatement. In many cases the same facts will support a finding of 'inherent' or 'apparent agency'. Usually it is not necessary for a third party attempting to hold a principal to specify which type of authority he relies upon, general proof of agency being sufficient. Pacific Mut. Life Ins. Co. of California v. Barton, 5 Cir., 1931, 50 F.2d 362, certiorari denied 1931, 284 U.S. 647, 52 S.Ct. 29, 76 L.Ed. 550. In the case at bar Lind attempted to prove all three kinds of agency; actual, apparent, and inherent, although most of his evidence was directed to proof of 'inherent' or 'apparent' authority. From the evidence it is clear that Park & Tilford can be held accountable for Kaufman's action on the principle of 'inherent authority'. Kaufman was Lind's direct superior, and was the man to transfer communications from the upper executives to the lower. Moreover, there was testimony tending to prove that Herrfeldt, the vice- president in charge of sales, had told Lind to see Kaufman for information about his salary any that Herrfeldt himself had confirmed the 1% Commission arrangement. Thus Kaufman, so far as Lind was concerned, was the spokesman for the company. It is not necessary to determine the status of the New York law in respect to 'inherent agency' for substantially the same testimony that would establish 'inherent' agency under the circumstances at bar proves conventional 'apparent' agency. The Restatement, Agency 2d 8, defines 'apparent agency' as 'the power to affect the legal relations of another person by transactions with third persons, professedly as agent for the other, arising from and in accordance with the other's manifestations to such third persons.' There is some uncertainty as to whether or not the third person must change his position in reliance upon these manifestations of authority, but this is of no consequence in the case at bar since Lind clearly changed his position when he
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accepted the job of district manager with its admittedly increased responsibilities. *** The opinion of the court below and the argument of the appellee here rely heavily on Gumpert v. Bon Ami Corporation, 2 Cir., 1958, 251 F.2d 735, a diversity case decided under New York law, upholding the lower court's reversal of a jury verdict for the plaintiff. The facts in that case showed that Gumpert had been hired by Rosenberg, a director and member of the executive board of the Bon Ami company for a salary of $25,000 in cash plus $25,000 worth of the company's common stock. The Court of Appeals found that the jury could not properly find that the Bon Ami company had clothed Rosenberg with apparent authority to offer Gumpert $25,000 in common stock. This decision is inapposite for here we deal with an offer made by an employee's immediate superior, the man who represented the company to those under him, not a contract offered by one not an officer of a corporation to prospective employee. Furthermore a salary of $25,000 in cash and $25,000 in common stock might well be deemed unusual enough to put the prospective employee on notice as to a possible lack of authority in the director to make the offer but the same may not be said of an offer of a commission to a salesman who had been habitually working on that basis, in a corporation that confined itself to selling others' products. It should be borne in mind also that a director, even if he be a member of the executive board, does not ordinarily hire employees. Moreover in the case at bar there was evidence by an employee of Schenley that at least some state managers received 1% Commissions. Testimony was adduced by Schenley tending to prove that Kaufman had no authority to set salaries, that power being exercisable solely by the president of the corporation, and that the president had not authorized Kaufman to offer Lind a commission of the kind under consideration here. However, this testimony, even if fully accepted, would only prove lack of actual or implied authority in Kaufman but is irrelevant to the issue of apparent authority. The opinion below seems to agree with the conception of the New York agency law as set out above but the court reversed the jury's verdict and the judgment based on it on the conclusion, as a matter of law, that Lind could not reasonably have believed that Kaufman was authorized to offer him a commission that would, in the trial judge's words 'have almost quadrupled Lind's then salary'. But Lind testified that before he had become Kaufman's assistant in September 1950, the latter position named being that which he had held before being 'promoted' to district manager in April 1951, he had earned $9,000 for the period from January 1, 1950 to August 31, 1950, that figure allegedly representing half of his expected earnings for the year. Lind testified that a liquor salesman can expect to make 50% Of his salary in the last four months of the year owing to holiday sales. Thus Lind's salary two years before his appointment as district manager could have been estimated by the jury at $18,000 per year, and his alleged earnings, as district manager, a position of greater responsibility, do not appear disproportionate. On the basis of the foregoing it appears that there was sufficient evidence to authorize a jury finding that Park & Tilford had given Kaufman apparent authority to offer Lind 1% Commission of gross sales of the salesmen under him and that Lind reasonably had relied upon Kaufman's offer. *** HASTIE, Circuit Judge, with whom KALODNER, Circuit Judge, joins (dissenting). I agree that the order granting judgment for the defendant notwithstanding the verdict for the plaintiff, must be set aside. However, I think the majority make a serious mistake when they take the extraordinary additional step of reversing the alternative order of the trial judge, granting
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a new trial because he considered the verdict against the weight of the evidence. This court has never before reversed an order of a trial judge granting a new trial because of his conclusion on all of the evidence that the jury had reached an unjust result. At least, neither I nor any of my colleagues can find a precedent in our court for such action. Rather, we have recognized that the function in question is broadly discretionary, 'requir(ing) that the trial judge evaluate all significant evidence, deciding in the exercise of his own best judgment whether the jury has so disregarded the clear weight of credible evidence that a new trial is necessary to prevent injustice.' See Zegan v. Central R. Co. of New Jersey, 3 Cir., 1959, 266 F.2d 101, 104. The opinions of other court cited by the majority not only recognize that discretion but also emphasize its extreme breadth. This traditional conception of the role of the trial judge has provided the one important limitation on the power of the jury to make an unimpeachable decision on the facts, even where the evidence is conflicting. The judge may not substitute the verdict he would have rendered on the evidence for that actually rendered by the jury. But he may avoid what in his professionally trained and experienced judgment is an unjust verdict by vacating it and causing the matter to be tried again by a second jury. Thus, the essential institution of jury trial is respected and an expedient middle ground is maintained between the absence of any control over a jury's verdict on conflicting evidence, on the one hand, and judicial usurpation of the fact finding function, on the other. Under this scheme the only function of a reviewing court, once the trial court has ordered a new trial, is to see whether there can have been any basis in reason for the trial judge's conclusion as to the weight of the evidence and the injustice of the verdict. The majority do not challenge this view, though they do not state explicitly what their understanding of our role is. The present record discloses a sharp conflict of testimony whether Kaufman, the metropolitan sales manager, ever promised plaintiff, his subordinate district manager, a 1% Commission on all gross sales of agents working under plaintiff. There are several remarkable aspects of this alleged promise which could reasonably have influenced the trial judge on this decisive issue. This commission would have more than quadrupled plaintiff's salary of $150 per week, making him much higher paid than his immediate superior, Kaufman, or any other company executive, except the president. No other sales manager or supervisor received any such commission at all. Moreover, after the alleged promise was made, month after month elapsed with no payment of the 1% Commission or indication of any step to fulfill such an obligation. Yet plaintiff himself admits that he made no formal demand for or inquiry about the large obligation for several years, and said nothing even informally about it to anyone for many months save for an occasional passing verbal inquiry said to have been addressed to Kaufman. The trial court may have reasoned that the amount said to have been promised was so abnormally large and plaintiff's concern about nonpayment so unnaturally small as to make it incredible that the promise ever was made. In addition, the very vagueness of the alleged promise and the absence of any mention of time in it may have increased the incredulity of the judge who heard the evidence. In such circumstances it was neither arbitrary nor an abuse of discretion for the trial judge to grant a new trial. Whether in the same circumstances some other trial judge or any member of this court would have let the verdict stand is beside the point. The majority thinks the trial judge usurped the function of the jury. I think it is we who
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are impinging upon the function and discretion of the trial judge in a way that is serious, regrettable and without precedent in this court.

QUESTIONS ON LIND 1. What type of authority is the plaintiff relying on in this case? Why not simply argue that Herrfeldt had actual authority? 2. What was the scope of Kaufman's authority? What must plaintiff show to prevail on his claim that the commission at issue what within the scope of that authority? 3. What are the defendant's two arguments that there was no authority? In particular, assuming plaintiff reasonably believed that Kaufman could set salaries, what argument does defendant have that Kaufman did not have authority to obligate it to pay this particular salary? 4. If plaintiff had lost the claim that Kaufman had authority to make the initial deal, could he possibly make another claim as to why the firm should be liable?

QUESTIONS ON HUMBLE/HOOVER 1. What is the basis of the plaintiff's claim that either oil company should be liable for a tort that occurred at a service station the oil company did not own. 2. Can a plaintiff win simply by showing that there was a principal/agent relationship, or must plaintiff show that there was some special P/A relationship? What type? 3. What is the critical legal issue determining whether P. is liable? 4. What did each court hold? 5. Can you distinguish the cases and argue that both courts were right?

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INTRODUCTION: THE CORPORATE STRUCTURE2

A. The Corporate Form Alice is the sole owner of a successful start-up enterprise that produces widgets. The value of that enterprise is $1 million. Alice just discovered a new technology which would cut the costs of producing widgets by 3/4. However, Alice needs an additional $20 million to develop the technology for commercial use. Unfortunately, she does not have the required cash herself. So Alice is looking for some outside parties who are willing to put up the necessary funds. Question: Consider the different ways in which Alice could raise $20 million. What kinds of things would outside parties ask for in exchange for their funds. In particular, consider different options for Alice and these parties (i) to divide the cash flow generated from the future sale of widgets; and (ii) to allocate between themselves the right to control the widget enterprise. The corporation is the standard form of almost all large U.S. firms. The chief attributes of the corporate form are generally listed as: 1) limited liability for investors; 2) free transferability of investor interests; 3) legal personality (entity-attributable powers, indefinite life span, and purpose); and 4) centralized management. From a doctrinal perspective, the key attributes of corporate form all depend, directly or indirectly, on the legal identity of corporations as distinct "persons" apart from their shareholders and directors. State corporation statutes establish this identity and provide the basic rules governing relationships among corporate shareholders, directors, and managers. What factors might cause Alice to favor a corporation over a partnership? (What arent all business organized as corporations?) In addition to the common features of the corporations, however, there are also crosscutting differences among corporations that are at least as important as the distinction between corporations and partnerships. Small or "closely-held" corporations (so named because their shares seldom trade) that incorporate for tax or liability purposes often attempt to avoid other standard features of corporate law that seem inappropriate to their status as "incorporated partnerships." By contrast, corporate law is generally better suited to large or at least largish firms with numerous shareholders ("public" or "publicly-traded" firms). B. Key Players Within the Corporation The decision to form a corporation requires that Alice make some decisions about what
2

Based on materials drafted by Marcel Kahan

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role she wants to play in the new firm and to understand the duties and limitations that corporate law places on each of the potential roles available to her. Basically, there are three classes of people that share power: stockholders, directors and officers. Shareholders (a.k.a. stockholders). The main source of power for shareholders is that they elect directors. Generally, all directors are elected every year at an annual meeting of shareholders. If shareholders are dissatisfied with the directors, they can (i) elect different directors at the next annual meeting; or (ii) in some circumstance remove directors either at a special meeting or by written consent (i.e. by signing a form stating that they want to remove them). The scope and the (legal as well as practical) limitations of shareholder voting rights will be discussed in Part III of the materials. Directors. Directors have the legal power to manage the corporation. This means that directors decide how to run the business operations, how much salary they receive, and how much is distributed to shareholders in dividends. (If a corporation decides to distribute money to its shareholders, it pays dividends.) In managing the business, directors are generally not bound by directions given to them by the shareholders. All directors together form the board of directors or, in short, the board. Officers. Officers help the directors to manage day-to-day business operations. Officers have fancy titles (such as President and Chief-Executive Officers). Despite these fancy titles, they are, as a legal matter, bound by directions given to them by the board of directors. Directors that are also officers (or otherwise employees) of the company are commonly referred to as inside directors. Directors that are not otherwise affiliated with the company are outside directors. Outside directors generally do not spend much of their time in managing the company, are often hand-picked by the inside directors, and receive, relative to inside directors, a small amount of compensation. (For example, in 2002, Rusell T. Lewis, the President and CEO of The New York Times, received a salary of about $1 million, a bonus of $1.5 million, a longterm incentive plan award of $200,000, 20,000 shares of restricted stock worth about $900,000, and stock options on 150,000 shares worth an estimated $1.9 million. The outside directors of The New York Times received a retainer of $30,000, $1,000 for each board or committee meeting attended, and options on 4,000 shares.) Directors (in particular inside directors) and/or officers are sometimes also referred to as management. (Note that, while these terms appear in case law, popular and academic writing, they are not used in the DGCL.) Even though, as a matter of law, all directors have equal powers, the real power is often exercised by the CEO. Shareholder Management Powers. Though directors have the general power to manage the corporations, certain extraordinary decisions require as well the approval of shareholders. These decisions include: (i) the dissolution of the corporation; (ii) a sale by the corporation of all of its assets; (iii) a merger of the corporation with another corporation (a merger of two corporation essentially means that they become one corporation that holds all the assets and owes all the liabilities previously held or owed by either one of the two corporations);

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(iv) an amendment to the certificate of incorporation (more on the certificate is to follow soon). C. The Incorporation Process3 Forming a corporation is simple. In Delaware, it involves filing a certificate of incorporation with the Secretary of State and paying a fee. One or more incorporators sign the articles and deliver them to the state of incorporations secretary of states office, along with a check for any applicable fees or taxes. The secretary of state retains the original articles and returns a copy to the incorporator with a receipt for the fee. Unless the articles provide to the contrary, the corporation comes into existence at the moment the secretary of states office accepts the articles for filing. Modern articles of incorporation usually are bare-bones documents, containing little more than the statutorily mandated terms. Model Business Corporation Act (MBCA) 2.02(a), for example, requires the articles to contain only four items: Name. A corporations name may not be the same or confusingly similar to that of another corporation incorporated or qualified to do business in the state of incorporation. The name must also include some word or abbreviation indicating that the business is incorporated, such as corporation, company, Inc. or the like.
Authorized shares. The articles must state the maximum number of shares the corporation is authorized to issue. o Classes and series of shares. Corporate stock may be separated into multiple classes and series. If the corporation wishes to do so, the articles must identify the different classes and state the number of shares of each class the corporation is authorized to issue. Where one or more classes of shares have certain preferential rights over other classes, those rights must be spelled out in this part of the articles. Registered agent. The articles must state the name of the corporations registered agent and the address of its registered office. The registered office must be located within the state of incorporation. The registered agent receives service of process when the corporation is sued. Incorporators. The articles must state the name and address of each incorporator. Statement of Purpose: A number of states, prominently including Delaware, still require that the articles contain a statement of corporate purpose. It is sufficient, however, to state that the purpose of the corporation is to engage in any lawful act or activity . . . . DGCL 102(a)(3).

The articles of incorporation may be amended at any time. A three-step process is normally involved. First, the board of directors must recommend the amendment to the shareholders. Second, the shareholders must approve the amendment. Finally, the amendment must be filed with the secretary of states office. Bylaws are the rules a corporation adopts to govern its internal affairs. Bylaws tend to be far more detailed than the articles of incorporation, for three reasons: (1) bylaws need not be filed with the state government, which means they are not part of any public record; (2) bylaws are more easily amended than articles of incorporation (see below); and (3) officers and directors tend to be more
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From the update to Bainbridge, Klein and Ramseyer

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familiar with bylaws than with the articles, which makes them a ready repository of organizational rules. In the event of a conflict between a bylaw and the articles, the latter controls.

The bylaws typically deal with such matters as number and qualifications of directors, board vacancies, board committees, quorum and notice requirement for shareholder and board meetings, procedures for calling special shareholder and board meetings, any special voting procedures, any limits on the transferability of shares, and titles and duties of the corporations officers. The Sources of Corporate Law Before one can file the Articles/Certificate, one must pick a state of incorporation. This can be, but need not be, the firms primary place of business. Indeed, often it is not. The reason for this is that the state of incorporation generally determines the legal regime which will apply to the internal affairs of the firm. This brings us to an examination of the sources of corporate law. The primary emphasis of corporate law is on the relationship between (and among) the corporation, its shareholders, and its directors. (If you are not familiar with the terms shareholders and directors, you should think of shareholders as the "owners" of the corporation -i.e. those who are ultimately entitled to the profits the corporation makes -- and of directors as the "managers" of the corporation -- i.e. those who decide how to run the corporation.) There are several sources that define these relationships. Some of these sources are laws (statutes or case law); other are regulations promulgated by federal (or, less commonly, state) agencies; others are contractual. 1. State Corporation Law A. Corporation Statutes The most important laws on corporations are the state corporation statutes. Each corporation is (primarily) governed by the state corporation statute of the state in which the corporation is incorporated. Each corporation generally has the choice to incorporate in any one of the 50 states. Thus, when one decides to form a corporation, one basically has the choice between 50 laws to be governed by. Though these corporation statutes differ from state to state, a century of borrowing and reform efforts by the corporate bar have contributed to a general uniformity of structure. The task of analyzing state law is made even simpler by the fact that one state, Delaware, has emerged as the state of incorporation of choice for the majority of large U.S. corporations. In light of the special position of Delaware, we will focus chiefly on the Delaware General Corporation Law ("DGCL"), which is contained in the Statute, Rules and Forms booklet that you should have purchased. To get a sense of what a state corporation statute contains, you should leaf through the table of contents of the DGCL. The first three subchapters relate to formation of a corporation. Subchapter I ( 101-110) deals with the formation process, the certificate of incorporation and the by-laws. Subchapter II ( 121-127) deals with corporate powers and subchapter III ( 131136) with certain procedural requirements. The next four subchapters relate to the ordinary aspects of the corporate existence.

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Subchapter IV ( 141-145) contains the provisions on directors and officers; subchapter V ( 151-174) those on stocks and dividends. Subchapter VI ( 201-203), while short, is quite important. It contains the section on stock transfer restrictions and the Delaware anti-takeover provision (which we will study in detail later on in the course). Subchapter VII ( 211-230) deals with stockholder voting. (The DGCL uses the term stockholder; many other states, including New York, use the term shareholder). The next five subchapters relate to extraordinary events: subchapter VIII ( 241-246) deals with changes in the certificate of incorporation or in the equity capital structure; subchapter IX ( 251-263) with mergers; subchapter X ( 271-285) with major asset sales and dissolutions; subchapter XI ( 291-303) with certain aspects of insolvency; and subchapter XII ( 311-314) with the raising of the dead. Subchapter XIII ( 321-330) discusses procedures for suing corporations. Subchapter XIV ( 341-356) contains special provisions for corporations that elect to be "close" corporations. Subchapters XV ( 371-385) and XVI (( 388-389) deal with non-Delaware corporations that want to do business in or become domesticated in Delaware. (These few provisions are exceptions to the general rule that corporations are governed by their state of incorporation.) Subchapter XVII ( 391-398), innocently named "Miscellaneous Provisions," also contains the section on taxes and fees. State Case Law Not all of the state corporation law is contained in the corporation statutes. Equally important is the state case law. In particular, case law (and not statutory law) defines the two important duties owed by directors and officers to the corporation and its shareholders: the duty of care (i.e. the duty not to be negligent in managing the corporation) and the duty of loyalty (i.e. the duty to manage the company for the benefit of the shareholders, and not for their own personal benefit). These duties will be further discussed in Part II. In Delaware (though not in most other states) corporate cases are heard by a specialized trial court: the Court of Chancery. The Chancery Court has five judges (one Chancellor and four Vice-Chancellors) and has jurisdiction over all disputes arising under Delawares corporate law (and some others). There are no juries in the Chancery Court. All decisions are thus rendered by judges that have a fair degree of subject-matter expertise. Appeals from the Chancery Court are heard by the Delaware Supreme Court, which has five members and normally sits in panels of three judges. A limited cast of characters is thus responsible for the generation of most of the important state case law. Federal Law and Regulations The main source of federal law of corporations is the Securities Exchange Act of 1934 (also referred to as the 1934 Act, the Exchange Act, or the Securities Exchange Act). The Exchange Act (together with the Securities Act of 1933, which is not important for our purposes) forms the core of a complex regulatory scheme. As part of that scheme, Congress established the Securities Exchange Commission (SEC) and empowered it to enforce the provision of the Exchange Act and to promulgate detailed rules and regulations in a number of areas. For our purposes, the most important of these regulations are those on voting, on acquisitions of corporations, and on insider trading.

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Corporate Contracts Apart from legal rules, the relationship between shareholders, directors, officers, and the corporation is governed by two documents which are similar to contracts: the certificate of incorporation (a.k.a. charter) and the by-laws. The various sources of rights discussed above form a hierarchy. On top of the hierarchy are federal laws (and regulations). If state law is inconsistent with federal law, federal law governs. Next are the state corporation statutes and (below) state case law. Then comes the charter. Charter provisions are only valid if they are not inconsistent with federal or state law. Finally, there are the by-laws. By-law provisions are trumped both by federal and state law and by the charter. (Note, however, that corporation statutes will often contain "default" rules, i.e. rules that, by their terms, can be modified by charter or by-law provisions. Such rules will contain phrases such as "unless otherwise provided in the corporation's certificate of incorporation ..." See, e.g., DGCL 141(i).) A. The Certificate of Incorporation Every corporation must have a charter. Indeed, a corporation is formed by filing the charter with the Secretary of State. A charter contains two kinds of provisions: mandatory and optional ones. The provisions that must be contained in the charter are listed in DGCL 102(a). The provisions that may be contained in it are listed in DGCL 102(b). In reading the statute, pay attention to the following questions: 1. Which charter provisions are mandatory? Are all mandatory provisions contained in the charter? If not, can you come up with an educated guess why? 2. Which charter provisions are optional? Why where these provisions included? Do they have a common theme? (Hint: how do these provisions affect the standard allocation of power between shareholders and the current directors?) Which of the optional provisions are required to be in the charter (if they are included anywhere) and which provisions can be put in the bylaws or the charter. This is very important as you will see during the Patterson problem below. Note on ultra vires An issue of little practical relevance today (but of enough historical importance that it is often raised in older cases and that you should know what it is about) are corporate actions that are outside of the corporate purpose and therefore exceed the corporate powers (in Latin, ultra vires). In the dark ages of corporation law, the powers of a corporation imposed significant constraints on corporate activities and ultra vires was a colorable defense against third-party contract claims (i.e. the corporation could assert that it was not liable under a contract to a third party since it lacked the power to enter into the contract). Modern statutes and charters, however, impose almost no limits on the corporate purpose and powers. See DGCL 102(a)(3). Thus, the issue of ultra vires arises infrequently. In the rare instances in which ultra vires is an issue, the possible consequences are laid out in DGCL 124. You should be sure to read this statute.

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B. By-Laws Almost all corporations also have by-laws. DGCL 109 specifies how by-laws are adopted or changed and what provisions may be contained in them. Many by-law provisions are technical (and boring). While some governance provisions must be contained in the charter (see, e.g., DGCL 141(k)(i)), others can be either in the charter or the by-laws (see, e.g., DGCL 216 or 141(d) ). If one has the choice, why would a company chose to put provisions into its by-laws rather than into its charter, and vice versa?

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Basic Concepts in Valuation and Corporate Finance4

We now examine a number of basic finance notions that are important for the understanding of corporate law: the time value of money, risk and return, diversification, and capital market efficiency. Time Value of Money The basic notion of the time value of money is simple: $1 today is more valuable than $1 tomorrow. How much more depends on the time value of money. If you want, the time value of money is similar to a rental charge: $1 today is worth $1 tomorrow plus whatever you could get for "renting" out $1 for one day. (Of course, since we are dealing with money, we would talk about lending, rather than renting money out, but the concept is the same.) From time value of money flow the concepts of discount rate and present value. Present value is simply the value today of money at some future (or, for that matter, past) point. Thus, if $1 in ten years would have the same value as 38.5 cents today, 38.5 cents would be the present value (the value today) of receiving $1 in ten years. The discount rate tells us how to calculate present values. Mathematically, the present value (i.e., the value in todays dollars) of, say, $10 receivable (or payable) one year from now is obtained by dividing $10 by 1 + the discount rate for next year. If that rate is, say, 10%, the present value would be $9.09. For amounts of money receivable (or payable) in two, three, etc. years, the process of discounting has to be repeated for each year. That is, the present value of $10 receivable 3 years from now, if the discount rate for each of these years is 10%, would be $10/(1+.1)3 = $7.51. Present value analysis is used to determine whether one should invest money into an investment project. The general rule is that one should invest if and only if the net present value of a project is positive. Net present value is just the sum of the present values of all the amounts receivable if one invests less the sum of the present values of all the amounts payable if one invests. In other words, a project is good if, after converting to present values, one gets out more than one pays. Risk and Return So far we have dealt with a world of certainty. In real life, future returns on most investments are uncertain or risky. We thus have to examine how uncertainty affects the concepts of discounting and net present value discussed before. In the process of doing so, I will also clarify exactly what we mean by risk. The introduction of uncertainty requires essentially two adjustments to the simple discounting process: first, since returns on an investment are no longer certain, we have to calculate expected future cash flows, and discount these expected cash flows; second, we (may) have to adjust the discount rate.

Based on materials drafted by Marcel Kahan

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Problem For example, a firm offers you a choice of four salary packages: (1) $100,000 for sure (2) 50% chance of 0 and a 50% chance of $200,000 (3) 50% chance of 60,000 and a 50% chance of 150,000 Which offers the greatest expected return? Which one would you select and why? What factors are relevant to your decision other than expected return? Expected Return The expected cash flows on an investment are simply the weighted average cash flow. Assume, for example, that you bet $10 on a horse race. If you win, you will get $50, if you lose you will get nothing. If the probability of winning is 15%, your expected cash flows on the investment "$10 bet on a horse race" is $7.50 (15% times $50 and 85% times nothing). Risk Preferences The expected return simply tells us the average return. It does not tell us anything about how risky the investment is. The concept of risk relates to the possibility that actual realized cash flows will deviate from expected cash flows. In the horse race example, the actual realized cash flow will be either $42.50 above (with a 15% likelihood) or $7.50 below (with a 85% likelihood) the expected cash flow. The greater the deviations, and the greater the likelihood of deviations, the greater the risk of a project. (The commonly used statistical measure of risk is called variance; for this course, you do not need to know how variance is calculated, but merely what is measures.) In the salary problem above, which of the salary packages carries the most risk? Studies show that investors are generally risk averse, that is they prefer less risk to more risk (other thinks being equal). For such an investor, risk is a negative quality, and she has to be compensated for risk. This compensation is provided by discounting risky expected future cash flows at a higher discount rate. We call this rate a "risk-adjusted rate." By contrast, the rate at which we discount future cash flows that are certain is the risk-free rate. The difference between the risk-adjusted rate and the risk-free rate is called risk premium. The proper risk premium for a project depends on the amount (and, as we shall see, on the type) or risks the project entails. Thus, there are multiple discount rates for each time period: one risk-free rate and many riskadjusted rates. Most investment projects will involve some risk. One project, however, involves no (or at least virtually no) risk. That project is buying (government) treasury securities. The yield that you earn on buying treasury securities will therefore equal the risk-free discount rate for the corresponding time period.

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Problems on Net Present Value, Risk and Return (1) Assume that the prevailing interest rate on Treasury Bills is 5%, what is the net present value of the right to get $100 (with 100% certainty) in three years? (2) Assume that the prevailing interest rate on Treasury Bills is 5%. What is the most you should pay today for the right to invest in a project that will pay you has a 50% chance of paying you $2,000 and a 50% change of paying $1,000 in one year (assume the project ends then). Also assume that you are risk neutral (in that you do not care about the variance of your returns). (3) Consider the following problem: National Hotel wants to borrow $10 million from First City Bank to expand its operations. National has offered to close out the loan at the end of one year, paying First City Bank $11.3 million. The probability that National will do this is 95%. There is a 5% probability that National will not be able to repay anything. The risk free interest rate is 6.5%. First City requires an additional 2% risk premium on any investments with risk. Should First City make the loans? (i) What nominal interest rate is National Hotel offering First City interest rate does First City get if National pays back in a year) (2) What is the Expected Interest rate at the end of the first year? (3) What is the net present value of the hotel project to First City? Diversification The preceding discussion begins our analysis of risk. There is, finally, one more twist to the basic intuition about risk. Risk aversion means that investors are only averse to risky investments that they (or someone else) actually has to end up bearing. By constructing a portfolio of projects, an investor can reduce the risk she bears: the risk of the portfolio will be less than the average risk of the investments in the portfolio. A risky investment that an investor holds as part of a portfolio of other investments involving different risks is likely will thus add less risk to the investor, and therefore be worth more to its owner, that if it were held alone. Even if one of your investments goes sour, chances are very low that all of your investments will fail. (This relates to the adage "Don't put all your eggs in one basket" for which Franco Modigliani earned the Nobel Price in Economics.) The process of reducing risk by investing in many different projects is called diversification. Note that diversification involves different levels. Compare Investor 1 that has all her wealth in stock of Exxon, Investor 2 that has all her wealth in stock of 10 big oil companies, Investor 3 that holds stock of 500 U.S. companies operating in different industries, Investor 4 that holds stock in U.S. companies, U.S. government and municipal bonds, and real estate investments, and Investor 5 that holds U.S. stocks and bonds, gold, Japanese real estate, foreign currency, and stocks of European companies. Compared with the Investor 1, Investor 2 is fairly diversified against risks that are specific to Exxon (such as huge liabilities for oil spills); but Investor 2 is not well diversified (What

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against risks affecting the oil industry (such as the possibility of an increase in gas taxes or a Mideast War). Investor 3 is well diversified against industry risk, but not well diversified against risks affecting American industries as a whole (such as an increase in U.S. corporate taxes). Investor 4 is more diversified, but are her investments are still concentrated in the U.S. Investor 5 is even more diversified, having invested in the U.S., Japan, Europe and in gold and foreign currencies. Even an investor that is as diversified as investor 5 will still be subject to some risk. The reason is that not every risk is diversifiable, i.e. not every risk disappears if you hold a very large portfolio. (However, if the risk of a project is fully diversifiable, you would use the risk-free discount rate in order to determine the present value of the project.) Take the extreme case of a nuclear war: surely the value of the investments by investors 5 would decline. Nuclear war is, of course, not the only risk that is undiversifiable. Generally, if you have to figure out whether a certain risk is diversifiable, ask yourself whether an investor that holds a tiny portion of all possible investments in the world would be affected by whether the risk occurs. Take a decline in Exxon's profits by 50%. Exxon may be a big company, but 50% of its profits constitutes such a minuscule amount of all investments in the world that they would be barely noticeable. Take on the other hand a recession in the United States and Europe. The answer here is a clear yes. Such a recession would have a large negative impact on the value of many investments, and would even be noticeable to a fully diversified investor. And remember that the world economy is intertwined: a recession in the United States and Europe is likely to cause a world-wide recession. Finally take an earthquake in New York, destroying a major portion of the New York's real estate (but miraculously not involving any loss of life). The answer here is a maybe. The direct economic losses of the earthquake would be substantial (though probably by themselves not enough to be non-diversifiable). But in addition there would be major indirect losses: many people would be out of work (since their offices are destroyed), the operations of many companies would be disrupted, your law school records could be lost delaying your timely graduation, etc. The last thing to remember about diversification is that, to be fully diversifiable, it is not sufficient that any single investor is not obligated to bear the risk; rather, no investor must have to bear the risk. Take again a recession in the U.S. and Europe. It is surely possible for any single person to diversify the risk of such a recession, e.g. by investing mainly in gold, U.S. government securities, stock of South-East Asian companies, and becoming a bankruptcy attorney at a major New York firm. Indeed, such an investor would probably profit from a recession. However, it is not possible for all investor to diversify against the risk: not everyone can become a bankruptcy attorney; there is not enough gold in the world; someone, indeed many investors, must hold stocks of European and American companies. Therefore, the risk or such a recession is not diversifiable: that is, investors who end up bearing the risk (those who do own U.S. stocks etc.) must be compensated for bearing the risk by a risk premium. (Those who chose not to bear the risk, of course, will not get the risk premium.) Problem on Diversification Assume that a person living in Phantasia can invest only in the following four investment projects. She can loan money to the Phantasia government (which borrows $100 million per year) at an interest rate of 6% (in which case she is sure to be repaid next year). She can buy

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stock of either one (or both) of Phantasia's two leading baseball teams. If the Phantasia Mets win the annual baseball championship, Mets stock will sell for $100 a share and the stock of the losing Phantasia Yankees will sell for $50 a share one year from now; if the Yankees win, Yankee stock will sell for $100 a share and Mets stock for $50 a share one year from now. Each team has a 50% chance of winning the championship and that each of the baseball teams has 3 million shares issued and outstanding. Finally, she can buy stock of Phantasia Tourism Inc., a local hotel and restaurant operator (which has 4 million shares issued and outstanding). If, one year from now, Phantasia has completed the construction of its airport, tourists will start flocking in and Phantasia Tourism stock will be worth $300 a share. However, if the airport is not completed one year from now, Phantasia Tourism stock will only be worth $30. The likelihood that the airport will be completed in time is 20%. Question 1: Which of these investments involve risk? diversifiable? Which involve risk that is undiversifiable? Which involve risk that is

Question 2: In light of your answer to Question 1, what discount rates should be applied to each of these investments. What is the highest price you should be willing to pay for one ticket in the Mets assuming you only buy one ticket. What if you buy two tickets: one in the Mets and one in the Yankees? Phantasia Tourism stock? (If you cannot figure out an exact price, could you estimate a range of reasonable prices?). Assume you are risk neutral. Assume also that debt securities trading on the market with a similar 20% probability of full repayment are offering an interest rate of 14%. In reality, most projects will involve certain risk that is diversifiable and certain risk that is not diversifiable. For instance, the value of stock of General Motors depends both on the quality of the new GM models compared to Ford, Toyota, and BMW models (diversifiable risk since you could buy Ford, Toyota, and BMW stock) and on whether the world economy is going to enter into a prolonged recession (undiversifiable risk). The appropriate risk premium and riskadjusted discount rate, however, depends only on the undiversifiable portion of the risk. Thus, to modify our conclusion from above, the higher the amount of undiversifiable risk, the higher is the risk premium and the risk adjusted discount rate. Capital Market Efficiency Traditional discounting concepts are a sturdy guide to the logic of valuing both tangible and financial assets such as stocks and bonds. These concepts yield a theoretically satisfying notion of intrinsic value. To be sure they are difficult to apply. Who knows what appropriate discount rates are on risky investments? Discounting is an art and a search for comparable investments with an established costs of capital. Nevertheless, these techniques are routinely used, with various elaborations and a lot of prayer, by investment bankers in valuing takeovers, small businessmen and courts in valuing shares in closely-held corporations, bankruptcy courts in valuing plans for reorganizing businesses, and managers in valuing corporate projects. For some assets such as stock and oil, however, there is an alternative mode of valuation. The assets are bought and sold in a well-functioning market with many traders. Thus, it is easy to find a market price. In the case of stock, we need only pick up the business section of The Wall Street Journal. This raises an obvious question: How do the market prices of publiclytraded stocks relate to possible estimates of their intrinsic value, based on discounting their

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expected dividends? It would be exceedingly convenient -- not to say socially valuable -- if securities prices reflected very well-informed estimates, based on all available information, of the discounted value of the expected future payouts of corporate stocks and bonds. That is, it would simplify matters greatly if market prices aggregated the best estimates of the best-informed traders about the underlying present value of corporate assets -- net of payments to creditors, taxes, and all the rest. One of the core working hypotheses of modern financial economics is that the stock market manages to do just this. Stock prices efficiently -- that is, very rapidly -- reflect all public information bearing on the expected value of individual stock. This is the Efficient Market Hypothesis (EMH), or more precisely, the semi-strong form of the EMH. (The strong form of the EMH posits that stock prices rapidly reflect both public and non-public information.) As you will see in Part V of these materials, the EMH has had an important influence on developments in federal securities law. By contrast, it has met a more skeptical reception in the Delaware courts. Consider the following from Paramount Communications, Inc. v. Times, Inc. (Del. Ch. July 14, 1989), slip op. at 47-49: The legal analysis that follows treats the distinction that the Time board implicitly drew between current share value maximization and long-term share value maximization. For some, this is a false distinction. `The lawyers may talk about a premium for control. But to a true believer of efficient markets, there cannot be a premium for control.'* Therefore, before turning to the legal analysis that does employ that distinction, I pause to address in some brief way the notion that the distinction between any long-term and short-term stock value, at least where there is a large, active, informed market for the shares of the company, is an error; that the nature of such markets is precisely to discount to a current value the future financial prospects of the firm; and that markets with their numberless participants seeking information and making judgments do this correctly (at least in the limited sense that no one without inside information can regularly do it better). This view may be correct. It may be that in a well-developed stock market, there is no discount for long-term profit maximizing behavior except that reflected in the discount for the time value of money. ... Perhaps wise social policy and sound business decisions ought to be premised upon the assumptions that underlie that view. But just as the Constitution does not The statement is Professor Martin Shubik's, [who] apparently is not a true believer in efficient markets. He goes on to suggest: If, in contradistinction to the adherents of the single, efficient market, we suggest that there are several more or less imperfect markets involving the market for a few shares, the market for control, the market for going-business assets, and the market for assets in liquidation, then we have a structure for interpreting what is going on in terms of arbitrage among these different markets. Shubik, Corporate Control, Efficient Markets, and the Public Good, KNIGHTS, RAIDERS & TARGETS: THE IMPACT OF THE HOSTILE TAKEOVER, (Coffee, Lowenstein and Rose-Ackerman eds. 1988).
*

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enshrine Mr. Herbert Spencer's social statistics, neither does the common law of directors' duties elevate the theory of a single, efficient capital market to the dignity of a sacred text. Directors may operate on the theory that the stock market valuation is "wrong" in some sense, without breaching faith with shareholders. No one, after all, has access to more information concerning the corporation's present and future condition. It is far from irrational and certainly not suspect for directors to believe that a likely immediate market valuation of the [company's] merger will undervalue the stock. It is too early to address the difficult question of how accurately the EMH actually describes prices in the securities market. The EMH is surely approximately right, however, on some level. When oil firms announce big strikes, their stock prices rise commensurately; and when Texaco incurred a $10 billion liability judgment, its share prices fell commensurately. So, let us provisionally suppose that share prices do reflect rational best estimates, based on public information, about the value of corporate projects (Professor Shubik not withstanding), and return to the corporate form.

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Corporate Securities and Capital Structure

Introductory Note Even if the formal legal problems associated with invoking the corporate form are minor, two aspects of the incorporation decision are critical. Small businesses must ask, first, whether to incorporate at all. This is primarily an issue of tax planning and secondarily one of the relative advantages of the corporate form over the partnership or LLC (limited liability company) form. Assuming that the decision to incorporate is made, the second question at the incorporation phase is fixing the terms of the deal. The basic contours of the deal among corporate participants must be reflected in the design and distribution of corporate securities. On the most general level, the corporation must raise capital either by obtaining equity contributions (i.e. stock) or by borrowing. Raising capital through both of these devices yields a "capital structure:" a hierarchy of claims against the revenues generated by the business. Creditors who have hard contractual rights to interest and the repayment of principal must be paid first; stockholders (i.e. corporate equity holders) may then receive distributions in the form of dividends or stock repurchases as the corporation's board of directors decides. All of the corporation's equity -- and often much of its debt -- are raised by "issuing" (i.e. selling) securities. The notes and questions that follow examine some of the common varieties of securities that corporations issue, beginning with stocks. Equity Securities An ownership interest in a business is conventionally said to include two formal rights: a claim on the firm's residual earnings (i.e., the earnings that remain after workers, suppliers, creditors, and taxing authorities are paid); and a right to participate in the control of the business. For corporations, these rights reside in one or more classes of tradable stocks. Separating ownership rights from the identities of individual participants in the firm allows great flexibility. It means that portions of the value of the business can be bought and sold, control over management policies can change hands, and all owners of the company can turn over without altering the legal structure of the firm or renegotiating the terms on which equity holders participate in the firm's earnings and control. The flexibility of corporate stock is not merely a function of its tradability, however. Corporation statutes place very few restrictions on precisely how control rights and earnings claims are to be allocated among classes of stock. This means that the initial incorporators of a business are free to structure complex deals among disparate initial contributors to a corporation's assets (for example, the entrepreneurs and investors who join forces in venture capital firms) merely by distributing stocks with different control rights and claims on residual earnings. Yet notwithstanding the infinite variety of equity securities that a corporation might issue to raise capital, most stocks fall into two generic categories: common stock and preferred stock. Common stock is the most basic corporate security: the stock that usually carries the voting rights to elect the corporation's board of directors and the stock that receives dividends (or liquidating distributions) after all other participants in the corporation have been paid. In small corporations, common stock is often the only class of stock. In large public corporations,

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common stock is stock as you know it: the stock that most analysts follow, that corporate raiders buy in takeovers, and that business reporters discuss when talking about the financial health of the corporation. The barebones rights of common stockholders are governed by the corporation statute and, more generally, applicable state and federal law. They may also be further articulated by the corporate charter. Although it is usual to have only one class of common stock with identical distribution and voting rights, the corporate charter may provide for several classes. Multiple classes of common stock might differ in control rights: for example, holders of Class A common might receive 10 votes per share in the election of directors, while holders of Class B might receive only one vote per share. It is even possible (although rare) for different classes of common stock to differ in distribution rights: for example, in the case of USX today, holders of one class of shares receive dividends keyed to the performance of the company's steel assets while holders of another class receive dividends keyed to the performance of its oil assets. Despite such differences in payout and control rights, however, multiple classes of common stock remain "common" because they hold residual claims for dividends or other distributions that can only be exercised after other claims against the firm and its earnings are satisfied. By contrast, preferred stock is, as the name implies, stock with a claim on the company's residual earnings or assets that comes ahead of common stock. The precise rights of preferred stockholders vary from issue to issue, and are defined either in the corporate charter or, more commonly, in a separate "certificate of designation" drafted pursuant to a provision of the charter empowering the board to issue preferred stock. Generally, preferred stock pays a fixed dividend that must be paid before common stock receives any dividend payment. As with common stock, the board of directors of the corporation has the discretion to withhold dividends from holders of preferred stock (Preferred stock is still stock, so there is no hard and fast contractual obligation to pay dividends on it.) The point, however, is that if preferred must be paid before common receives anything, there is considerable pressure on the board to pay preferred dividends. This pressure may be further enhanced by giving preferred limited control rights. Generally, preferred stock does not carry the right to vote for directors, but the preferred contract may shift this right from common to preferred stock if no dividends are paid to preferred holders for an extended period such as six quarters. (If nothing is said about voting rights in the corporate charter or certificate of designation, the presumption is that preferred stock carries the same voting rights as common stock.) Finally, preferred stock may also be redeemable by the corporation for a price, or convertible by its holder into shares of common stock at a pre-set ratio. Forms of Debt In addition to equity, corporations obtain capital through debt. In general, there are three main sources of debt: trade debt, bank debt, and bonds (unsecured bonds are also called debentures and bonds with a maturity of less than 10 years are also called notes). Trade debt consists mainly of debt owed to suppliers and shows up in a balance sheet as accounts payable. The terms of trade debt are mostly straightforward: payment of the amounts due within a certain (relatively short) period of time. The terms of bank debt and bonds are more complex. Such debt can be secured or unsecured. Other corporations sometimes guarantee the payment of such debt. The interest rate on bank debt or bonds may be fixed or may fluctuate. Bank debt is sometimes issued under a revolving credit agreement -- that is, the corporation does not borrow the whole amount when the agreement is signed, but rather borrows (and repays) amounts as needed (naturally, up to a

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certain limit). Just like Integrated Resources Preferred Stock was redeemable by the company, bonds are often redeemable (or callable) by the corporation -- e.g. the company may have the right to redeem ("call") a $1,000 bond for, say, $1,005. Other bonds contain sinking fund provisions requiring the company to redeem or repurchase a certain amount of bonds each year. Call provisions are also referred to as optional redemption, and sinking funds as mandatory redemption provisions. Some bonds are contractually subordinated to other specified debt (called senior indebtedness); in such a case, holders of subordinated debt are not paid until the holders of senior indebtedness have been paid in full. Other bonds are convertible into common stock. Most bonds pay interest in cash at a fixed rate. Other bonds are "zero-coupon", i.e. they pay no interest, but when they become due the company must pay an amount significantly higher than the amount the company received when the bond was sold (e.g., a $1,000 zero-coupon bond due 1995 may have been issued in 1985 for $400). A few bonds pay interest at rates that vary over time. For example, the interest rate may be tied to the rate paid by the U.S. Government on treasury bills plus a fixed premium. Furthermore, bank debt agreements and the "agreements" under which bonds are issued (called "indentures") generally contain limitations on what a company may do (called "covenants"). These covenants can, for instance, limit the right of the company to pay dividends, to make certain investments, or to incur additional debt. In short, the terms of bank debt and bonds differ widely. For the moment, it is not necessary for you to memorize these differences. However, you should try to obtain some familiarity with the terms since these terms will reappear throughout the course and, more importantly, in the legal practice of those of you who will deal with corporations. Creditor Priority The most significant difference between debt and equity is, of course, that if a company is dissolved or liquidated (or, more commonly, if a company goes bankrupt) the company's assets have to be used first to repay the creditors. Only after all the debt is paid in full are the remaining assets handed over to the shareholders. In other words, debt has priority in payment over equity. As a general rule, in a dissolution or liquidation, all debt has equal priority: no one debt is has the right to be paid off before any other debt. Thus, if a company's assets are not sufficient to pay all the debt in full, the debt is paid off pro rata. That is, each creditor receives, in payment of her claim, a fraction of the amount of the debt owed to her that equals the fraction of the total assets held by the company to the total debt owed by the company. Assume, for example, that ABC Inc. has $5 million in assets and owes $2 million to Mark, $3 million to Nora, and $5 million to Olga. The total amount of debt owed by ABC is then $10 million and the fraction of total assets to total debt is 1/2. Thus, each of Mark, Nora and Olga get 1/2 of the respective amount owed to them. There are 3 important exceptions to the general rule that all debt has equal priority. First, the federal Bankruptcy Code establishes certain classes of debt (e.g. unpaid taxes) which have priority over other debt in a federal bankruptcy case. We will not deal with this exception.

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Second, there is secured debt. Secured debt is secured by certain assets; such assets are called "collateral." If debt is secured, the collateral is used first to pay off the debt secured by the collateral. If, after paying the secured debt, some collateral is left over (e.g. if the collateral was worth $100 million and the secured debt owed was only $60 million), the remainder ($40 million) is distributed pro rata among the unsecured debt. If the collateral is not sufficient to pay the secured debt in full (e.g. if the secured debt owed was $100 million but the collateral was worth only $70), the unpaid portion of the secured debt (i.e. $30 million) is treated like another $30 million of unsecured debt, i.e. it receives a pro rata portion of the assets that do not constitute collateral. Third, there is subordination. Think of subordination as a arrangement between creditors in which some creditors agree that their debt is subordinated to the (senior) debt owed to certain other creditors. (Thus, there are three kinds of debt: subordinated debt, senior debt, and debt owed to creditors which are not party to this arrangement and which therefore is neither subordinated nor senior.) Subordination means that, if the company that owes the debt (the debtor) does not repay the senior debt in full, the holders of subordinated debt will pay any deficiency, but only to the extent they receive payment by the debtor on account of their subordinated debt. That is, the holders of subordinated debt subordinate their right to be repaid to the right of the holders of senior debt to be repaid.

Problem: Capital Structure and Leverage

The hierarchy of the corporations equity and debt capital together constitute a capital structure. The more the company borrows to finance its business projects instead of relying on equity contributions, the more leveraged its capital structure is said to be. The important thing to know about leverage is that it increases the riskiness of the equity and that it increases the expected rate of return on equity if the expected rate of return on assets exceeds the interest rate. Consider the following example: Alice needs $100,000 to invest in her widget business. If the business does well, she expects profits (before interest) of $16,000 a year. If the business does poorly, she expects annual profits of $8,000. She believes that it is equally likely that the business will do well and that it will do poorly. Thus the expected rate of return of the widget business (the "expected rate of return on assets") is 12%. Alice has two options to raise the $100,000. She can either use her savings to finance the full amount (all equity-no leverage), or she can put in only $50,000 of her savings and borrow the other $50,000 from bank at an interest rate of 10% (a rate below the 12% expected rate of return on assets). If Alice uses $100,000 of her own money, her company has no debt and has to pay no interest. Since the company is "all equity", the expected rate of return on equity is equal to the expected rate of return on assets, i.e. 12%. If Alice borrows $50,000, the bank will require her to pay interest of $5,000 for the year. Alice's equity participation will be only $50,000. (She will be earning interest on the remaining $50,000 invested in savings). How does this affect Alices returns? If the business does well, she earns $16,000 and pays the bank $5,000, leaving her with $11,000. Of course, Andrew only invested $50,000. This means that she gets a rate of return of 22%. If the business does poorly, it earns only $8,000. Alice pays the bank $5,000, leaving her with only $3,000. This represents

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a rate of return on equity of only 6%. Given this, her expected rate of return is 14%. This exceeds the rate of return on her all equity investment. Observe, however, that the leveraged investment not only produces a higher expected return, it also is riskier, in that it increases the variances in your rate of return. Why is this? The key to both the increased returns and the increased riskiness of debt financing lies in the fact that debt financing usually requires the debtor to repay the loan at an interest rate which is fixed externally (and does not depend on profits earned). Given this, when the investment does well, the investor gets to keep more of the residual. But when the investment does poorly, the investor must pay out a greater percentage of the earnings to debt. To see this, examine Alices earnings in the bad state of the world. When Alice uses only equity, in the bad state she earns only $8,000 but does not have any additional costs. By contrast, when Alice obtains debt financing, in the bad state she earns $8,000 but still has to pay interest of $5,000. Thus, Alice's equity investment has become more volatile, or riskier. If things go well, leverage increases Alice's rate of return on equity; but if the business does poorly, leverage decreases Alice's rate of return. Also consider the effect of leverage on Alices risk premium. Since, given our assumption, the bank would be sure to be repaid its $50,000 loan, the 10% interest rate on the loan represents the risk-free rate. If Alice were to finance her widget business with no debt, her expected rate of return on equity would be 12%. Alice would thus earn a 2% risk premium. If Alice were to finance her widget business with $50,000 in equity and a $50,000 loan, her expected rate of return on equity would be 14% - a 4% premium over the risk-free rate. In this example leverage doubled the risk premium. And it also doubled risk, as measured by the differences between possible actual returns and expected returns. To see this, lets consider how Alice fares under equity. State 1 (the firm does well) she gets $8,000 (her share of the $16K), which is a 16% return on her $50,000 investment. In State 2 (firm does badly) she gets $4,000 (her share of $8,000) which is a 8% return on her $50,000 investment. So the difference between actual returns and expected returns of 12% is 4%. Now consider debt financing. In State 1 she gets $16 and pays $5,000 for a profit of $11,000. This is a 22% return. In State 2, she gets $8,000 and pays $5,000 for a profit of $3,000. This is a return of 6%. The difference between actual returns and expected returns here is 8%. For additional discussion of this point as well as all of the finance topics covered in this section, see Klein & Coffee, Business Organization and Finance. A more rigorous treatment may be found in Brealey & Myers, Principals of Corporate Finance.

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LIMITED LIABILITY AND THE RIGHTS OF CREDITORS A. Limited Liability Limited liability heads every short list of basic attributes of the corporate form. Within the doctrinal framework of corporate law, nothing could seem more natural than the rule that shareholders enjoy the protection of limited liability: Since the corporation is a contracting entity separate from its shareholders, how could shareholders be liable for corporate debts beyond their investment in shares? Indeed, this rule is so fundamental that corporation statutes have only recently begun to codify it. Because limited liability represents a radical break with the common law liability rules of agency and partnership, however, its value was not always so obvious. Shareholders only gradually won the protection of limited liability for private business ventures in the United States during the first half of the 19th Century. Great Britain, by contrast, established limited liability by legislative fiat with the Limited Liability Act of 1855. Something of the change in attitude toward limited liability over the 19th Century is suggested by the following two views. THE TIMES of London declared in an 1824 editorial: "Nothing can be so unjust as for a few persons abounding in wealth to offer a portion of their excess for the information of a company, to play with that excess for the information of a company - to lend the importance of their whole name and credit to the society [i.e., the company], and then should the funds prove insufficient to answer all demands, to retire into the security of their unhazarded fortune, and leave the bait to be devoured by the poor deceived fish."* By contrast, the ECONOMIST was to declare in 1926: The economic historian of the future may assign to the nameless inventor of the principle of limited liability, as applied to trading corporations, a place of honour with Watt and Stephenson, and other pioneers of the Industrial Revolution. The genius of these men produced the means by which man's command of natural resources has multiplied many times over; the limited liability company produced the means by which huge aggregations of capital required to give effect to their discoveries were collected, ** organized and efficiently administered." Setting aside the troublesome problem of tort creditors, the chief consequence of limited liability is to bound how much shareholders must risk on the downside, and thus to permit "risky" debt: That is, limited liability permits shareholders to shift some of the risk of business failure to debtholders. As you know from the leverage reading, more debt often means higher expected returns to shareholders and, to the extent that debtholders expect risk to be shifted, higher interest rates as well. Somewhat less obviously, limited liability also alters control over corporate assets. Shareholders with limited liability can more easily abandon responsibility for the obligations of the firm that goes bankrupt. Thus, limited liability implies that creditors rather As quoted in Halpern, Trebilcock, & Turnbull, An Economic Analysis of Limited Liability in Corporate Law, 30 U. TORONTO L. REV. 117, 117 (1980).
* **

Id.

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than shareholders will control the business over a broader range of circumstances in which it performs poorly. In short, limited liability is a complicated standard-form term in the relationship between corporate creditors and shareholders. Agency Costs of Debt The possibility that creditors are not assured to be repaid in full (which is increased by limited liability) results in potential conflicts of interest between shareholders and creditors. Shareholders, and not creditors, elect the board of directors, which in turn manages the company. Creditors may thus reasonably fear that, unless restrained, companies will act in the interest of shareholders where shareholder interests conflict with those of creditors. But that the agents (inhere the directors) do not fully take into account the interest of all their principals (inhere the creditors) may have undesirable consequences. These undesirable consequences are called "agency costs of debt." (Later on, we will deal with agency costs of equity, which result from the fact that directors do not fully take into account the interests of shareholders.) Agency costs of debt come in three basic flavors. First, actions by companies which are in the interest of shareholders, but not in the combined interest of shareholders and creditors. Second, the costs of designing contracts or laws designed to prevent managers from taking such actions. Third, the costs of monitoring compliance with such contracts or laws. To understand the distortions created by limited liability, it is useful to return to our preceding discussion of leverage (supp. 22-23). In the discussion above, the availability of debt financing alters the expected returns and the riskiness of Alices investment, but does not distort her choices. Specifically, it does not alter her incentive to invest in the project only if the expected net present value of the return is positive. The reason for this is that, no matter what, Alices venture will have the money to repay the loan and must honor that obligation. Therefore, she inevitably bears the downside risk of her choices. This is not always the case, however. In some situations, the returns from a project should things go badly may be less than the amount the business owes to its creditors. In this case, should things go badly, the creditors may bear the loss, in addition to equity. The likelihood of creditors bearing losses is enhanced when the business is organized as a corporation because corporations enjoy limited liability. Limited liability potentially enables corporate owners (shareholders) to retain the upside gains of their investment while shifting most of the downside risk to other people (creditors or tort victims). To see this consider the following problem.

Problem on the Agency Costs of Debt

Assume that Alice has formed a corporation and is considering a choice between two year long projects, which each require a 6,000 investment. Assume her firm got a loan of $6,000 at 5% interest. Alice can choose between the following two projects: Project 1: Earns $12,000 with 50% probability and 9,000 with 50% probability in year Project 2: Earns $18,000 with 50% probability and 0 with 50% probability. Please answer the following questions: (1) Which project would society (our economy) prefer that Alice invest in? (Which earns the highest expected return?)

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(2) Which project would Alices creditor (lender) prefer that she invest in? (3) Which project would Alice invest in if she was investing personally (and not through a corporation?) (4) Which project will Alice have her corporation invest in (assuming that the corporation is formed solely for this purpose and intends to liquidate when the project is over). Why? Are shareholders led to prefer projects that involve more risk or less risk? Are creditors led to prefer projects that involve more risk or less risk? (Remember, in the example all risk was diversifiable. How are the answers affected by this assumption?) What other actions can companies take that benefit shareholders and harm creditors? Try to draft legal or contractual rules that would eliminate or reduce some of the agency costs of debt. In drafting these rules, take into account the legitimate interests of both shareholders and creditors. Why Do We Have Limited Liability? Given the substantial distortions created by limited liability, the answer naturally arises, why does corporate law permit it. Related to this is the issue of how far should it extend? In thinking about these questions, it may be helpful to consider the following commentators: Easterbrook & Fischel, Limited Liability and the Corporation, 52 University of Chicago Law Review 89, 93-97 (1985) A. Limited Liability and the Theory of the Firm People can conduct economic activity in many forms. Those who perceive entrepreneurial opportunities must decide whether to organize a sole proprietorship, general or limited partnership, business trust, close or publicly held corporation. ... Limited liability for equity investors has long been explained as a benefit bestowed on investors by the state. It is much more accurately analyzed as a logical consequence of the differences among the forms for conducting economic activity. Publicly held corporations typically dominate other organizational forms when the technology of production requires firms to combine both the specialized skills of multiple agents and large amounts of capital. The publicly held corporation facilitates the division of labor. The distinct functions of managerial skills and the provision of capital (and the bearing of risk) may be separated and assigned to different people -- workers who lack capital, and owners of funds who lack specialized production skills. Those who invest capital can bear additional risk, because each investor is free to participate in many ventures. The holder of a diversified portfolio of investments is more willing to bear the risk that a small fraction of his investments will not pan out. Of course this separation of functions is not costless. The separation of investment and management requires firms to create devices by which these participants monitor each other and guarantee their own performance. Neither group will be perfectly trustworthy. Moreover,

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managers who do not obtain the full benefits of their own performance do not have the best incentives to work efficiently. The costs of the separation of investment and management (agency costs) may be substantial. Nonetheless, we know from the survival of large corporations that the costs generated by agency relations are outweighed by the gains from separation and specialization of function. Limited liability reduces the costs of this separation and specialization. First, limited liability decreases the need to monitor. All investors risk losing wealth because of the actions of agents. They could monitor these agents more closely. The more risk they bear, the more they will monitor. But beyond a point more monitoring is not worth the cost. Moreover, specialized risk bearing implies that many investors will have diversified holdings. Only a small portion of their wealth will be invested in any one firm. These diversified investors have neither the expertise nor the incentive to monitor the actions of specialized agents. Limited liability makes diversification and passivity a more rational strategy and so potentially reduces the cost of operating the corporation. Of course, rational shareholders understand the risk that the managers' acts will cause them loss. They do not meekly accept it. The price they are willing to pay for shares will reflect the risk. Managers therefore find ways to offer assurances to investors without the need for direct monitoring; those who do this best will attract the most capital from investors. Managers who do not implement effective controls increase the discount. As it grows, so does the investors' incentive to incur costs to reduce the divergence of interest between specialized managers and risk bearers. Limited liability reduces these costs. Because investors' potential losses are "limited" to the amount of their investment as opposed to their entire wealth, they spend less to protect their positions. Second limited liability reduces the costs of monitoring other shareholders. Under a rule exposing equity investors to additional liability, the greater the wealth of other shareholders, the lower the probability that any one shareholder's assets will be needed to pay a judgment. Thus existing shareholders would have incentives to engage in costly monitoring of other shareholders to ensure that they do not transfer assets to others or sell to others with less wealth. Limited liability makes the identity of other shareholders irrelevant and thus avoids these costs. ... Hansmann & Kraakman, The Uneasy Case for Limiting Shareholder Liability for Corporate Torts, 100 Yale Law Journal 1879 (1991) (copyright held by Yale Law Journal Company, Inc.) Limited liability in tort has been the prevailing rule for corporations in the United States, as elsewhere, for more than a century. This rule is generally acknowledged to create incentives for excessive risk-taking by permitting corporations to avoid the full costs of their activities. Nevertheless, these incentives are conventionally assumed to be the price of securing efficient capital financing for corporations. Although several authors have recently proposed curtailing limited liability for certain classes of tort claims or for certain types of corporations in order to control its worst abuses, even the most radical of these proposals retains limited shareholder liability as the general rule. Surprisingly, given the widespread acceptance of the prevailing rule, the existing literature contains no comprehensive comparison of the consequences of limited and unlimited liability for corporate torts. We offer such an analysis here. We argue, contrary to the prevailing view, that limited liability in tort cannot be rationalized for either closely-held or publicly-traded corporations on the strength of the conventional arguments offered on its behalf. In fact, there

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may be no persuasive reasons to prefer limited liability over a regime of unlimited pro rata shareholder liability for corporate torts. The question remains open chiefly because the merits of limited liability depend, as we demonstrate, on empirical issues that are difficult to resolve on the basis of available evidence. At a minimum, however, we conclude that the burden is now on the proponents of limited liability to justify the prevailing rule. ... Consider first the situation in which a single person forms a corporation, of which she is the sole shareholder and manager, to exploit an investment opportunity. The shareholder in this case could be an individual or -- more realistically and more importantly -- another firm of which the corporation in question is a wholly-owned subsidiary. Suppose that undertaking the investment creates a risk of tort liability exceeding the corporation's net value. ... The most familiar inefficiency created by limited liability is the incentive it provides for the shareholder to direct the corporation to spend too little on precautions to avoid [such liability]. In contrast, a rule of unlimited liability induces the socially efficient level of expenditure on precautions by making the shareholder personally liable for any tort damages that the corporation cannot pay. Further, limited liability encourages overinvestment in hazardous industries. Since limited liability permits cost externalization, a corporation engaged in highly risky activities can have positive value for its shareholder, and thus can be an attractive investment, even when its net present value to society as a whole is negative. Consequently, limited liability encourages excessive entry and aggregate overinvestment in unusually hazardous industries. ...
Creditor Protection

The fact that limited liability is now well established in corporate law does not mean that the fears of creditor exploitation voiced by its critics were unfounded. Limited liability creates obvious opportunities for shifting risks and withdrawing assets in ways that creditors cannot, or do not, anticipate. As you might expect, however, the law provides several compensatory devices that are intended to protect creditors. The most straightforward way to protect creditors, it would seem, would be a standard capitalization requirement: A rule that assured creditors a minimum fund of corporate assets to satisfy their claims. (What are the drawbacks of such a rule?) State corporation codes do not fix meaningful capitalization levels, but they do pursue a similar strategy by restricting dividend payments to shareholders when it appears that the firm is nearing insolvency, which is typically understood in balance sheet terms. These dividend restrictions exist in theory, but do not offer effective protection to creditors in practice. The remaining legal sources of creditor protection -- apart from the all-important contractual protections that creditors can arrange for themselves -- are fraudulent conveyance law on the hand, and a variety of equitable doctrines on the other. The chief equitable doctrines that we will review are equitable subordination, which refers to the circumstances in which insiders' debts are subordinated to outsiders debts in bankruptcy, and veil piercing, which refers to the circumstances in which the courts will set aside the entity status of corporations and permit creditors to hold shareholders liable directly. (An equitable doctrine in this context permits courts to act, or to refuse to act, under the aegis of vague maxims that seek to prevent fraud or injustice. We are left with the task of finding the courts' controlling policy or principle.) In examining the mechanisms discussed below (and in the casebook), consider the degree to which you think the law has provided adequate protections to voluntary creditors as opposed to involuntary creditors (tort claimants). For which type of creditor is the argument favoring

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limited liability the strongest/weakest? Which type of creditor appears to get the best/worst legal protections? 1. Fraudulent Conveyance Law Fraudulent conveyance law is a broad statutory framework for voiding any transfer made for the purpose of delaying, hindering, or defrauding creditors. The original fraudulent conveyance act was passed in 1571 by the English Parliament; modern state acts follow the model of the Uniform Fraudulent Conveyance Act or the updated Uniform Fraudulent Transfer Act. The Bankruptcy Code 548 contains a substantially identical set of provisions. The relevant provisions of the UFCA (as adopted in Pennsylvania) are discussed in the Gleneagles case that follows. One corporate context in which fraudulent conveyance law plays an important role is in creditor challenges to "leveraged buyouts" (LBOs). To simplify, the typical LBO transaction was designed to permit an acquirer to borrow, using the corporation's assets as collateral, a sum large enough to repurchase most of the corporation's publicly-held stock at a large premium. At the end of the day, the acquirer would own all of the corporation's remaining equity; the bulk of the corporation's capital would consist of debt incurred to finance the deal; and public shareholders would receive an enormous premium for their shares. Generally speaking, this outcome left the acquirer happy: if it succeeded in paying off the corporation's debt load, they would own the whole potato -- and become fabulously wealthy. It left public shareholders happy with a 50% premium over the market value of their shares. And it left LBO lenders happy, since they received a security interest in the corporation's assets, huge up-front fees, extremely high interest rates -- or all three. However, this outcome generally did not leave unsecured pre-LBO creditors of the corporation very happy. Their relatively safe debt became, over night, subject to a significant risk of default. When companies that underwent LBOs subsequently failed (some did, many did not), the claim was invariably made that the LBO amounted to a fraudulent conveyance. By and large these actions were not aimed at recouping the purchase price paid to public shareholders but at subordinating the debt claims of LBO lenders (e.g. the banks) and recouping fees and other benefits paid to LBO professionals. (Why do you think this is the case?) That is, the implicit policy argument of the pre-LBO creditors was that the LBO insider group, investment bank, and lenders ought to have screened deals more carefully and prevented transactions that had a high probability of subsequently ending in bankruptcy. 2. Equitable Subordination The equitable subordination doctrine permits bankruptcy courts to set aside the claims of shareholders or other insiders against a bankrupt corporation until the claims of outside creditors are satisfied. The doctrinal guidelines for invoking equitable subordination are vague, much like the guidelines for piercing the corporate veil (to which equitable subordination is closely related). Generally, the unlucky insider must be held to have behaved unfairly or wrongly toward the corporation and its creditors.

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3. Piercing the Veil The most radical check on limited liability is the equitable power of the court to set aside the entity status of the corporation ("piercing the veil") to hold its shareholders liable directly on contract or tort obligations. As with the equitable subordination doctrine, the common law guidelines for veilpiercing are vague. One common formulation is the Lowendahl test, which requires on the part of the defendant shareholder complete domination of corporate policy used to commit a fraud or "wrong" that proximately causes plaintiff's injury. Another formulation simply calls on courts to disregard the corporate form whenever recognition of it would extend the principle of incorporation "beyond its legitimate purposes and [would] produce injustices or inequitable consequences." Krivo Industrial Supp. Co. v. National Distill. & Chem. Corp., 483 F.2d 1098, 1106 (5th Cir. 1973). All courts agree that veil-piercing should be done sparingly; the question is how sparingly. A number of factors, moreover, typically play a role in veil piercing decisions: disregard of corporate formalities, thin capitalization, small numbers of shareholder, active involvement by shareholders in management -- and the list goes on.

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SEA-LAND II May 21, 1993, Decided OPINION: Appellants appeal from a judgment entered after a bench trial in the Northern District of Illinois, James F. Holderman, District Judge, piercing the corporate veil and awarding appellee $ 118,132.61 in damages. On appeal, appellants claim that the evidence presented at trial was insufficient to warrant piercing the corporate veil and that the court misapplied state law in reaching its conclusion. For the reasons which follow, we reject appellants' claims and we affirm the judgment in all respects. I. We summarize only those facts and prior proceedings believed necessary to an understanding of the issues raised on appeal. *** [Summarizes Sealand I] As to the second prong, however, we remanded because Sea-Land's failure to present evidence to support a finding that adherence to a separate corporate existence would promote fraud or injustice. Id. at 524. To satisfy this second prong, we concluded, SeaLand must establish on remand some "wrong" beyond its inability to collect on its judgment against PS. *** On the instant appeal, appellants contend that the evidence presented by Sea-Land at trial was insufficient to satisfy the second prong of Van Dorn. They also assert that the court misapplied Illinois law in reaching its decision. II. To pierce a corporate veil under Illinois law, a plaintiff must demonstrate that there is "such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist", and that "adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice." Van Dorn. In this case, we are concerned only with the latter requirement which appellants contend Sea-Land failed to satisfy. To determine whether Sea-Land satisfied its burden, we first look to our earlier decision in this case. In Sea-Land I we held that, to prevail on the second prong of Van Dorn, Sea-Land must establish, in addition to its inability to collect on its judgment, a "wrong" such as where: "the common sense rules of adverse possession would be undermined; former partners would be permitted to skirt the legal rules concerning monetary obligations; a party would be unjustly enriched; a parent corporation that caused a sub's liabilities and its inability to pay for them would escape those liabilities; or an intentional scheme to squirrel assets into a liability-free corporation while heaping liabilities upon an asset-free corporation would be successful." We went on to suggest that such "wrongs" could be shown by Sea-Land on remand if "Marchese . . . used these corporate facades to avoid its responsibilities to creditors; or that PS, Marchese or one of the other corporations will be 'unjustly enriched.'" Id. at 525.

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As a threshold matter, appellants contend that Sea-Land did not produce evidence between summary judgment and trial to establish a wrong other than its inability to collect on its judgment, and therefore did not satisfy the second prong of Van Dorn. As we recognized in SeaLand, supra, 941 F.2d at 524, the only reason Sea-Land did not present such evidence on summary judgment was because it believed its unsatisfied judgment was sufficient ground for piercing the corporate veil. At trial, however, Sea-Land did present new evidence pertaining to the additional wrongs listed above. Indeed, accountants testifying on Sea-Land's behalf relied on bank records and personal financial statements obtained between summary judgment and trial to support their testimony that Marchese was unjustly enriched and that he used his corporations as a sham to defraud creditors. Further, contrary to appellants' assertions, Sea-Land adduced sufficient evidence at trial to establish additional wrongs to justify piercing the corporate veil. First, Sea-Land demonstrated that Marchese and his corporations were unjustly enriched. We have defined "unjust enrichment" as the receipt of money or its equivalent under circumstances that, in equity and good conscience, suggest that it ought not to be retained because it belongs to someone else. *** At trial, Sea-Land demonstrated that Marchese obtained countless benefits at the expense of not only Sea-Land, but the Internal Revenue Service (IRS) and other creditors as well. Indeed, Marchese used PS funds to pay his personal expenses as well as expenses incurred by his other corporations. As a result, PS was left without sufficient funds to satisfy Sea-Land or PS's other creditors. ***. Since Marchese [HN5] was enriched unjustly by his intentional manipulation and diversion of funds from his corporate entities, to allow him to use these same entities to avoid liability "would be to sanction an injustice." *** Sea-Land also satisfied the second prong of Van Dorn by demonstrating at trial that Marchese used his corporate entities as "playthings" to avoid his responsibilities to creditors. An accountant testified that Marchese's payment of personal expenses with corporate funds enabled those corporations to avoid their monetary obligations to vendors, creditors, and federal and state tax authorities. One example was Marchese's withdrawal of $ 19,000 as salary from Jamar Corporation. This withdrawal rendered Jamar insolvent and thus unable to satisfy liabilities in excess of $ 450,000. Marchese also frequently took "shareholder loans" from the corporations to pay personal expenses, leaving the corporations with insufficient funds to satisfy liabilities as they became due. Further, a tax accountant testified that Marchese's business practices were replete with illegal transactions. Indeed, as we previously recognized, "for years Marchese flagrantly has disregarded the tax code concerning the treatment of corporate funds." Sea-Land, supra, 941 F.2d at 522 n.2. Marchese's practice of avoiding liability to Sea-Land and other creditors by insuring that his corporations had insufficient funds with which to pay their debts, is ground for piercing the corporate veil. *** Further, as the district court here properly recognized, Marchese was [HN8] the "dominant force" behind all of the corporations and was responsible for the manipulation and diversion of corporate funds without regard for creditors or the law. *** On the basis of the facts adduced at trial, the court properly concluded that Sea-Land satisfied the second-prong of Van Dorn and therefore was entitled to pierce the corporate veil. To support their claim that the court misapplied Illinois law to justify piercing the corporate veil, appellants seek to rely on Torco Oil Co. v. Innovative Thermal Co., 763 F. Supp. 1445 (N.D. Ill. 1991) (Posner, C.J., sitting by designation). They contend that Torco prohibited the court from piercing the corporate veil solely because defendants defrauded the IRS. Torco,

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however, is distinguishable because the court here did not rely solely on Marchese's tax violations to justify piercing the corporate veil. The court also relied on Marchese's defrauding creditors of his various corporations. Further, Torco also is distinguishable because it involved a "close case" of fraud, whereas in the instant case Marchese's fraudulent conduct was "blatant." Appellants further assert that Sea-Land fails to [HN9] satisfy the requirement that a nexus exist between its injuries and the fraud or injustice committed by appellants. South Side Bank v. T.S.B. Corp., 94 Ill. App. 3d 1006, 419 N.E.2d 477, 50 Ill. Dec. 369 (1981). This claim fails, however, in view of the fact that Marchese assured Sea-Land in 1987 that it would receive payment from PS as long as there were sufficient funds. The court's findings that Marchese knew at that time that he would manipulate the funds of PS so as to insure that Sea-Land would not be paid, and that he eventually did manipulate those funds, were not clearly erroneous. [HN10] Since Marchese's intentional and improper financial maneuvering caused Sea-Land's inability to collect on its default judgment, the required nexus existed here. III. To summarize: We hold that the evidence presented at trial was sufficient to support piercing the corporate veil. We also hold that the court properly applied Illinois law in reaching its decision. AFFIRMED.

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ZAIST v. OLSON 154 Conn. 563; 227 A.2d 552 (1967) The plaintiffs brought this action against Martin Olson, The East Haven Homes, Inc., and Martin Olson, Inc. ... The essential facts, as found by the referee, may be summarized as follows: In 1943, Martin Olson, subsequently referred to as Olson, caused The East Haven Homes, Inc., which we shall call East Haven, to be incorporated. Two hundred shares of stock were issued, of which Olson received 198; the other two shares were issued, one each, to his lawyer and his bookkeeper. Olson was president, treasurer and a director. [T]hroughout all the dealings hereinafter related, he controlled East Haven and was empowered to sign all checks for it. During 1952 and 1953, Olson personally acquired land in Groton for the purpose of erecting a shopping center. In April, 1954, he requested the plaintiffs to submit, and the plaintiffs did submit, prices for clearing and grading this land. The terms were mutually agreeable, and the plaintiffs began the work, setting the account on their records under the heading "Martin Olson". Thereafter, and before any payment was made, Olson told the plaintiffs to send the bills to East Haven, and the plaintiffs did so, keeping their records variously in the names of Olson and East Haven. In 1954, Olson caused Martin Olson, Inc., hereinafter called Olson, Inc., to be incorporated; in it he owned, personally or as trustee for three of his minor children, thirty-two of the forty shares of issued stock. Olson was president and treasurer and in full control of the corporation from its inception until October, 1959. He and two of his children were the directors, and a son was vice-president. Thereafter, Olson quitclaimed a substantial part of his Groton land to Olson, Inc., which also acquired additional adjoining land from private owners. The plaintiffs continued to work on the land, known to them only as the Groton shopping center, unaware of any change in title. Olson, or in his absence his son, directed the work. In 1955, Olson, Inc., reconveyed part of the land to Olson. While the plaintiffs were at work on the Groton land, Olson and Olson, Inc., acquired land for a shopping center in New London. In 1955, Olson caused The New London Shopping Center, Inc., to be incorporated. Olson was president and treasurer of that corporation and held all the stock personally or as trustee for his three minor children. Thereafter, Olson, this time describing himself as either "of" or "acting for" East Haven, made three contracts with the plaintiffs for work to be done and materials to be furnished in developing the New London shopping center land. Later, Olson, Inc., voted to sell a large part of its New London land to The New London Shopping Center, Inc., which then had little if any capital funds, for $177,000, and Olson, as president, signed the deed. Meantime, East Haven voted to contract with Olson, Inc., to erect a shopping center in Groton for not over $450,000 and to contract with The New London Shopping Center, Inc., to erect a shopping center in New London for not over $1,700,000, but no such contracts were ever executed. While this was going on, the plaintiffs were continually working on the properties both in Groton and New London; and East Haven, with fixed assets consisting of office furniture, a few small tools and cars and a truck of small value, had neither the funds nor the equipment to construct either of the shopping centers. Nevertheless, East Haven ... engaged various contractors for both projects. Funds for the construction of both projects were provided by a bank loan of $1,700,000 secured by a mortgage given by The New London Shopping Center, Inc., the proceeds from which were paid over to East Haven. Neither corporation was able, with these funds, to complete the New London project, and Olson besought the lending bank for additional funds. To meet the lending bank's demand,

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Olson caused Viking, Inc., to be formed, to which The New London Shopping Center, Inc., conveyed a part of its land, which Viking, Inc., on the same day mortgaged to the lending bank for a loan of $650,000. Olson controlled, and was president, treasurer and a majority stockholder of, Viking, Inc., and was authorized by it to borrow such sums as he deemed advisable. The proceeds of the $650,000 loan were paid over to East Haven and used to pay bills on the New London project, and Viking, Inc., acting by Olson as its president, reconveyed to The New London Shopping Center, Inc., the land which was mortgaged to secure, and was covered by, the $650,000 mortgage. During the month after Viking, Inc., was formed, Olson, Inc., acquired a tract of land in Waterford on which the plaintiffs also worked under a contract with East Haven. Thereafter, The New London Shopping Center, Inc., was merged into Olson, Inc., the two corporations continuing under the name of Olson, Inc., which remained under the full control of Olson. A few months later Olson, Inc., quitclaimed a substantial portion of its Groton land to Olson after Olson had notified the plaintiffs that, owing to the financial status of East Haven, "we would not be in a position to discuss settlement with you for at least another four months." ... For five years subsequent to April, 1954, the plaintiffs had furnished labor, materials and equipment on the aforementioned lands in Groton, New London and Waterford to an amount in excess of $192,752.66, all of which labor, materials and equipment inured to the benefit of Olson and Olson, Inc. The plaintiffs had been paid $169,652.66 by checks of East Haven, of which an aggregate of $97,401.26 had been signed by Olson and the balance by his son as vice-president of East Haven. The balance owed to the plaintiffs as of December 31, 1959, was $23,100. The offices maintained by Olson, Olson, Inc., East Haven, The New London Shopping Center, Inc., and Viking, Inc., were all at the same address, and Olson's secretary was also

secretary and bookkeeper for Olson, Inc., and East Haven. East Haven was originally formed for the purpose of building homes and, prior to 1954, engaged in that and other construction work on property of Olson and others. During the period covered by the plaintiffs' work, East Haven maintained an office and a checking account, kept corporate and financial records, filed corporation returns, and had employees. The record is completely silent as to any similar activity or conduct on the part of any of the other corporations involved except for the single meeting of Olson, Inc., at which that corporation voted to sell land to The New London Shopping Center, Inc., for $177,000, and the single meeting of Viking, Inc., which authorized Olson to borrow such sums as he deemed advisable. The only corporate action found to have been taken by East Haven relating to these projects consists of the two votes authorizing contracts with Olson, Inc., which were never consummated, to erect shopping centers in Groton and New London. The referee concluded that East Haven, in all its dealings, was the agent of Olson and Olson, Inc. The defendants not only denied this agency but also claimed that no services, materials or equipment furnished by the plaintiffs inured to the benefit of Olson or Olson, Inc., and that neither of those defendants was indebted to the plaintiffs. The court concluded, in substance, that the referee could reasonably find that Olson transacted business as an individual and also through corporate entities under his control and that all of the services rendered by the plaintiffs inured to the benefit of Olson and Olson, Inc. The second portion of this conclusion requires no discussion. The facts recited demonstrate clearly enough that Olson or Olson, Inc., received the benefit of the plaintiffs' services and the materials and equipment furnished by them. It is the first portion of the conclusion which poses the question for decision, namely, that Olson transacted the business as an individual and through corporate entities under his control. Although Olson was the person with

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whom the plaintiffs dealt, he directed them to look to East Haven for payment, and the plaintiffs did so. All checks issued in payment of bills rendered were East Haven checks signed by either its vice-president or by Olson, who was its president. East Haven was, as a corporation, a separate legal entity. It must be assumed, from the facts found, that the plaintiffs undertook to deal with this corporation. The facts indicate that they were unaware of, and probably indifferent to, the identity of the owners of the property, who were to receive the actual benefit of their work. Nothing is indicated to warrant the conclusion that Olson ever enlightened them on this subject or that they ever asked him to do so. These circumstances did not prevent the plaintiffs, once they learned that their undertaking was for the benefit of Olson and Olson, Inc., from seeking to hold them, as they did in this action. ... The complaint alleged that East Haven was "the agent or instrumentality" of Olson and Olson, Inc. We think that it was the latter. Courts will disregard the fiction of separate legal entity when a corporation "is a mere instrumentality or agent of another corporation or individual owning all or most of its stock." ... The circumstance that control is exercised merely through dominating stock ownership, of course, is not enough. ... There must be "such domination of finances, policies and practices that the controlled corporation has, so to speak, no separate mind, will or existence of its own and is but a business conduit for its principal." ... In the present case, Olson, Inc., owned none of the stock of East Haven. On the other hand, Olson held a dominating stock interest in both East Haven and Olson, Inc., and was president, treasurer and a director of both corporations. It is not the fact that he held these positions which is controlling but rather the manner in which he utilized them. The essential purposes of the corporate structure, including stockholder immunity, must and will be protected when the corporation functions as an entity in the normal manner contemplated and permitted by

law. When it functions in this manner, there is nothing insidious in stockholder control, interlocking directorates or identity of officers. When, however, the corporation is so manipulated by an individual or another corporate entity as to become a mere puppet or tool for the manipulator, justice may require the courts to disregard the corporate fiction and impose liability on the real actor. ... It is because of this, [that courts have developed the "instrumentality" rule.] The instrumentality rule requires, in any case but an express agency, proof of three elements: (1) Control, not mere majority or complete stock control, but complete domination, not only of finances but of policy and business practice in respect to the transaction attacked so that the corporate entity as to this transaction had at the time no separate mind, will or existence of its own; (2) that such control must have been used by the defendant to commit fraud or wrong, to perpetrate the violation of a statutory or other positive legal duty, or a dishonest or unjust act in contravention of plaintiff's legal rights; and (3) that the aforesaid control and breach of duty must proximately cause the injury or unjust loss complained of. Lowendahl v. Baltimore & O.R. Co., 247 App. Div. 144, 157, 287 N.Y.S. 62 ... The facts in the present case are, beyond question, that Olson caused the creation of both East Haven and Olson, Inc., and thereafter completely dominated and controlled not only them but his other corporate creations. All shared the same office. All the work and material furnished by the plaintiffs went into land which, after being juggled about, came to rest in Olson or Olson, Inc. The record is significantly silent with regard to any formal corporate action by the directors or stockholders of any of the several corporations except in the insignificant instances specifically mentioned. ... East Haven had no sufficient funds of its own and acquired no funds for the work on its own initiative. It had no proprietary interest in the property on which the work was done, and, so far as appears, it gained nothing from whatever part it played in

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the transaction. Its domination and control are aptly defined in Lowendahl v. Baltimore & O.R. Co., supra, 154, namely, "a domination and control so complete that the corporation may be said to have no will, mind or existence of its own and to be operated as a mere department of the business of the stockholder." With no showing of any responsible corporate action of its own, it was used by Olson for the benefit of Olson and Olson, Inc. On the facts established, the cause of justice would not be served by denying to the plaintiffs the amount found due them and unpaid because of the inadequate resources of East Haven. We do not wish to be understood to countenance, by anything we have said here, the imposition of the legitimate indebtedness of a corporation upon a majority stockholder in derogation of his legal immunity merely because of the corporate control inherent in his stock ownership. The present case presents a set of circumstances far different from that. The only reasonable meaning to attach to the transactions spread upon this record is that East Haven undertook no obligation of its own to the plaintiffs, was financially unable to cope with the actual transaction, and reaped no benefit from it. The undertaking throughout was Olson's, planned and carried out through his various other corporate creatures for his own and Olson, Inc.'s, enrichment, a part of which, if the plaintiffs were to be denied a recovery, would consist of the amount which East Haven, as the plaintiffs' ostensible debtor, is unable to pay because Olson and Olson, Inc., have not provided the final necessary funds. ... Consequently, a judgment against Olson was warranted. The court could, with equal propriety, reach the conclusion that the identity of Olson and Olson, Inc., was such that judgment against Olson, Inc., was warranted. Cotter, J. (dissenting). I cannot agree with the conclusion of the majority that the "only reasonable meaning to attach to the transactions spread upon this record

is that East Haven undertook no obligation of its own to the plaintiffs, [and] was financially unable to cope with the actual transaction." The East Haven Homes, Inc., was organized as a general contractor in 1943. Thereafter, and over a period of several years, it built a large number of individual homes, a fifty-seven unit apartment house, a bank building, and several other commercial structures. In 1954, eleven years after it had been formed, East Haven Homes engaged the plaintiffs to do certain clearing work. From then until June of 1959, it paid them $169,652.66 for services rendered. East Haven Homes then apparently became insolvent, with an unpaid balance of $23,100 on this account. These facts, together with others recited in the majority opinion, support a conclusion that Martin Olson used his corporations to engage in speculative business undertakings, that these corporations borrowed funds, exchanged properties and undertook obligations in a free and easy fashion, and even that Olson structured a corporate network with a weak capital foundation, but they do not reasonably support the conclusion, made for the first time in this court, that "control [by Olson] was used to perpetrate an unjust act in contravention of the plaintiffs' rights." Indeed, it appears equally possible that Olson's entire corporate empire went into eclipse in 1960 and that East Haven Homes was merely a victim of this general financial decline. In my opinion, the record does not justify overriding the principle of a shareholder's limited liability. The practice of disregarding the corporate entity should be undertaken with great caution. This principle is fully applicable in situations where the corporation is dominated by a single individual. ... Persons dealing with such corporations may refuse to contract without a personal guarantee of payment from the principal. ... The plaintiffs in the present case, however, elected to deal with the corporation and in fact were paid substantial sums by the corporation over a long period of time. The underlying rationale behind the

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statutory granting of stockholder immunity from corporate debts has been stated as follows: "Obviously the useful and beneficial role of the corporate concept in the economic and business affairs of the modern day world would be destroyed if the rule of freedom from individual liability for corporate obligations did not obtain. The protection of limited liability for venture or investment capital is essential to the efficient operation of a system of free enterprise. Such protection from individual liability encourages and promotes business, commerce, manufacturing and industry which provides employment, creates sales of goods and commodities and adds to the nation's economic and financial growth, stability and prosperity." Johnson v. Kinchen, 160 So. 2d 296, 299 (La.). The majority opinion in the present case, although not directly undermining this principle, casts a doubtful shadow in its direction. The new rule which the majority has adopted as the test of the personal liability of a corporation's dominant shareholder is a broad one, will be difficult to apply realistically and is not warranted by the record in the present case. Close corporations, although individual entities from a legal standpoint, are normally no more than vehicles for the goals and motives of their principals. The law is not necessarily advanced by adopting a rule which includes a presumption that this kind of corporation may have a "separate mind, will, or existence of its own." Under the circumstances of this case, I would reaffirm the "fraudulent or illegal purposes" test. ...

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Questions on Zaist 1. What exactly did Olson do to justify piercing the corporate veil? What, if anything, differentiates this case from the run-of-the-mill closely-held corporation that runs into financial difficulties? 2. Is the dissent right in claiming that "[t] protection of limited liability for venture or investment capital is essential to the efficient operation of a system of free enterprise?" Maybe one ought to pierce the corporate veil whenever a corporation is completely controlled by a dominant shareholder? If not, what else should be required? 3. How could/should Zaist (the plaintiff) have acted to protect his interest as a creditor? Is it realistic to expect Zaist to act in such a way? Is it realistic to expect creditors generally to act in such a way? Tort creditors of thinly capitalized corporations differ from contract creditors in a key respect: They cannot negotiate with a corporate tortfeasor ex ante for contractual protections or compensation for bearing risk. Indeed, they may be totally unaware of the existence of the tortfeasor, much less able to monitor its capitalization or insurance coverage. The distinction between tort and contract creditors is well established in the law of agency and partnership, and it is generally recognized as important by commentators on corporate law. Nevertheless, it received surprisingly little explicit recognition in veil-piercing doctrine. The leading tort case remains Walkovszky v. Carlton, reprinted below. The general rule remains: Thin capitalization alone is an insufficient ground for piercing the corporate veil.

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MANAGEMENT'S POWERS AND DUTIES Centralized Management and the Business Judgment Rule After limited liability, the most frequently mentioned attribute of the corporate form is "centralized management." By this is meant the standard governance model that structures the corporation's internal relationship among shareholders, directors, and officers. The basic model applies to all corporations, large or small. Although the basic model is often extensively modified by shareholder agreements or other devices in the case of closely-held corporations, it generally applies with full force to public corporations. Review the readings on THE SOURCES OF CORPORATE LAW: STATE CORPORATION LAW in the Introductory Part of the course materials. Then consider the following (rather dated) New York case:

MANSON v. CURTIS Court of Appeals of New York 223 N.Y. 313; 119 N.E. 559 (1918)

COLLIN, J. ... In November, 1911, there existed a domestic corporation, the Bermuda-Atlantic Steamship Company. ... The corporate business was operating a steamship, the Oceana, between the city of New York and the islands of Bermuda. ... [Plaintiff and defendant, both shareholders of the corporation, entered into an agreement which provided:] "1. ... [T]hat the management [of the corporation] should continue in the same manner that it had in the past, and that plaintiff should continue as General Manager of the corporation and shape its policy [for one year]. "2. That any President of the corporation to be thereafter elected should be only a nominal head as President ... and that such President should not change, alter, molest, or interfere with plaintiff's methods of managing the corporate business affairs [for one year] ... It is not illegal or against public policy for two or more stockholders owning the majority of the shares of stock to unite upon a course of corporate policy or action, or upon the officers whom they will elect. An ordinary agreement, among a minority in number, but a majority in shares, for the purpose of obtaining control of the corporation by the election of particular persons as directors is not illegal. ... The respondent asserts and argues that the agreement before us contravenes a statutory provision and the policy of the state, because in intent and effect it withdraws from the directors of the corporation that control and direction of the corporate affairs and business which the statutes and the law vest in and confine to them. This assertion we will now consider. ... The fundamental and dominant intent and purpose of the agreement was that through its fulfillment there should be vested in or continue to be vested in the plaintiff solely and exclusively, for the period named, the executive administration of the affairs of the corporation. The parties agreed that through the period of one year after the making of the agreement the plaintiff should manage the corporate business and shape and control the corporate policy; that the president of the corporation should be only a nominal head and be inattentive to and non-interfering with the business or the policy or the plaintiff. ... The fundamental and dominant purpose and intent of the

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parties which necessitated and provided for a passive president of the board of directors necessitated likewise passive directors. The conditions which the parties wished to meet and their intent necessitated and contemplated the selecting of directors who should remain passive or mechanical to the will and word of the plaintiff. The management of the affairs of the corporation by its board of directors and the management of them by the plaintiff as contemplated by the agreement are irreconcilable and mutually destructive. The prerogatives and functions of the directors of a stock corporation are sufficiently defined and established. The affairs of every corporation shall be managed by its board of directors (General Corporation Law 34), subject, however, to the valid by-laws adopted by the stockholders. (Stock Corporation Law 30.) In corporate bodies, the powers of the board of directors are, in a very important sense, original and undelegated. The stockholders do not confer, nor can they revoke those powers. They are derivative only in the sense of being received from the state in the act of incorporation. The directors convened as a board are the primary possessors of all the powers which the charter confers, and like private principals they may delegate to agents of their own appointment the performance of any acts which they themselves can perform. The recognition of this principle is absolutely necessary in the affairs of every corporation whose powers are vested in a board of directors. ... All powers directly conferred by statute, or impliedly granted, of necessity, must be exercised by the directors who are constituted by the law as the agency for the doing of corporate acts. In the management of the affairs of the corporation, they are dependent solely upon their own knowledge of its business and their own judgment as to what its interests require. ... While the ordinary rules of law relating to an agent are applicable in considering the acts of a board of directors in behalf of a corporation when dealing with their persons, the individual directors making up the board are not mere employees, but a part of an elected body of officers constituting the executive agents of the corporation. They hold such office charged with the duty to act for the corporation according to their best judgment, and in so doing they cannot be controlled in the reasonable exercise and performance of such duty. As a general rule, the stockholders cannot act in relation to the ordinary business of the corporation, nor can they control the directors in the exercise of the judgment vested in them by virtue of their office. ... Directors are the exclusive, executive representatives of the corporation and are charged with the administration of its internal affairs and the management and use of its assets. ... Clearly the law does not permit the stockholders to create a sterilized board of directors. Corporations are the creatures of the state and must comply with the exactions and regulations it imposes. We conclude that the agreement here is illegal and void ... Questions on Manson v. Curtis 1. Consider Manson in conjunction with DGCL 102(b)(1), 141(a), and 351 (the latter provision applies only to close corporations). To what extent do these provisions modify the rule announced in Manson? 2. Why are corporations managed by a board of directors? What constituents may benefit or be hurt by such a management structure? 3. Where is the power of the directors derived from? Why is the Manson hostile to the notion of a passive board? Whose interests does the board represent? 4. Why should shareholders not be entitled to order the board to take certain management actions?

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AIRGAS, INC., v. AIR PRODUCTS and CHEMICALS, INC. SUPREME COURT OF DELAWARE November 23, 2010, Decided JUDGES: Before STEELE, Chief Justice, HOLLAND, BERGER, JACOBS, and RIDGELY, Justices, constituting the Court en Banc. OPINION RIDGELY, Justice: Air Products and Chemicals, Inc. ("Air Products") and Airgas, Inc. ("Airgas") are competitors in the industrial gas business. Air Products has launched a public tender offer5 to acquire 100% of Airgas's shares. The Airgas board of directors has received and rejected several bids from Air Products, including its latest offer that valued Airgas at $ 5.5 billion, because the board determined that each offer undervalued the company. During this entire attempted takeover period, the market price of Airgas stock exceeded Air Products' offers. To facilitate its takeover attempt, Air Products engaged in a proxy contest6 at the last annual meeting of Airgas stockholders. Airgas has a staggered board7 with nine directors, and three were up for election at that meeting. A staggered board, which Delaware law has permitted since 1899, enhances the bargaining power of a target's board and makes it more difficult for an acquirer, like Air Products, to gain control of its target without the consent of the board. At Airgas's last annual meeting held on September 15, 2010, Air Products nominated three directors to Airgas's board, and the Airgas shareholders elected them. Air Products also proposed a bylaw (the "January Bylaw") that would schedule Airgas's next annual meeting for January 011, just four months after the 2010 annual meeting. The January Bylaw, which was approved by only 45.8% of the shares entitled to vote, effectively reduced the full term of the incumbent directors by eight months.8 Airgas brought this action in the Court of Chancery, claiming that the January Bylaw is invalid because it is inconsistent with title 8, section 141 of the Delaware Code and the Airgas corporate charter provision that creates a staggered board.9 Airgas's charter requires an affirmative vote of the holders of at least 67% of the voting power of all shares to alter, amend, or repeal the staggered board provision, or to adopt any bylaw inconsistent with that provision. The Court of Chancery upheld the January Bylaw on the following basis: Airgas's charter provides that directors serve terms that expire at "the annual meeting of stockholders held in the third year following the year of their election." There is no inconsistency between Airgas's charter provision and the January Bylaw, because the January meeting would occur "in the third
[To class: A tender offer is where one firm buys the stock of the other firm. If it buys all the shares the target would be a wholly owned subsidiary. Klein & Coffee may be helpful in understanding this] 6 [Proxy contest: shareholder voting can happen in person or by proxy (the shareholder files a written form authorizing either management or someone else (here Air Products) to vote her shares)] 7 [Classified board and staggered board are different terms for the same thing. Read statutes in the syllabus for this class. The court says that a staggered board makes it harder for an acquirer to gain control. How does it do this (in what two ways?)]
5

[To class: Why did Air Products include this bylaw? Why not just use its control to remove the remaining directors and replace them with their own guys? Or, why not just declassify the board?]
[What is the precise claim? Normally, can shareholders adopt a bylaw that changes the date of the annual meeting?]
9

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year after the directors' election," which (the Court of Chancery found) was all that the Airgas charter requires. We conclude, as did the Court of Chancery, that the Airgas charter language defining the duration of directors' terms is ambiguous. We therefore look to extrinsic evidence to interpret the intent of the charter language which provides that directors' terms expire at "the annual meeting of stockholders held in the third year following the year of their election." We find that the language has been understood to mean that the Airgas directors serve three year terms. We hold that because the January Bylaw prematurely terminates the Airgas directors' terms, conferred by the charter and the statute, by eight months, the January Bylaw is invalid. Accordingly, we reverse. FACTS AND PROCEDURAL HISTORY The Charter, the Bylaws, and the Staggered Board of Airgas *** Ever since Airgas became a public corporation in 1986, it has had a three class staggered board by virtue of Article 5, Section 1 of its charter (the "Airgas Charter" or the "Charter"), which relevantly provides: Number, Election and Term of Directors. . . . The Directors . . . shall be classified, with respect to the time for which they severally hold office, into three classes, as nearly equal in number as possible as shall be provided in the manner specified in the By-laws, one class to hold office initially for a term expiring at the annual meeting of stockholders to be held in 1987, another class to hold office initially for a term expiring at the annual meeting of stockholders to be held in 1988, and another class to hold office initially for a term expiring at the annual meeting of stockholders to be held in 1989, with the members of each class to hold office until their successors are elected and qualified. At each annual meeting of the stockholders of the Corporation, the successors to the class of Directors whose term expires at that meeting shall be elected to hold office for a term expiring at the annual meeting of stockholders held in the third year following the year of their election. Similarly, Article III, Section 1 of Airgas's bylaws (the "Bylaws"), which implements Article 5, Section 1 of the Charter, relevantly provides: Number, Election and Terms. . . . The Directors . . . shall be classified, with respect to the time for which they severally hold office, into three classes, as nearly equal in number as possible, one class to hold office initially for a term expiring at the annual meeting of stockholders to be held in 1987, another class to hold office initially for a term expiring at the annual meeting of stockholders to be held in 1988, and a third class to hold office initially for a term expiring at the annual meeting of stockholders to be held in 1989, with the members of each class to hold office until their successors are elected and qualified. At each annual meeting of the stockholders, the successors or the class of Directors whose term expires at the meeting shall be elected to hold office for a term expiring at the annual meeting of stockholders held in third year following the year of their election. . . . Article 5, Section 6 of the Charter requires a supermajority vote to enact a bylaw that is inconsistent with Article III of the Bylaws. ****

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Article 5, Section 3 of the Charter requires a supermajority vote to remove an Airgas director without cause.10 *** Airgas has consistently held its annual meetings to enable the staggered directors to serve three year terms. Since it "went public" in 1986, Airgas has held its annual meeting no earlier than July 28 and no later than September 15 of each calendar year. Because Airgas's fiscal year ends on March 31, Airgas traditionally has held its annual meeting in late summer or early fall, to afford Airgas the necessary time to evaluate its fiscal year performance and prepare its annual report.11 Airgas always has held its annual meetings approximately twelve months apart. It has never held consecutive annual meetings sooner than eleven months, twenty-six days apart, or longer than twelve months, twenty-eight days since the prior annual meeting. Air Products' Takeover Attempt On February 11, 2010, Air Products commenced a tender offer for Airgas shares at a purchase price of $ 60 per share cash. ****** The Airgas board rejected all these bids as "grossly inadequate." The market for Airgas stock suggests that the board was correct**** After Airgas's board rejected Air Products' bids, Air Products could have negotiated with Airgas's board to agree on a mutually beneficial price. Instead, Air Products chose to wage a proxy contest to facilitate its tender offer. As part of its takeover strategy, Air Products nominated three persons to stand for election to Airgas's staggered board. Air Products also proposed three bylaw amendments including the January Bylaw, which relevantly provides: The annual meeting of stockholders to be held in 2011 (the "2011 Annual Meeting") shall be held on January 18, 2011 at 10:00 a.m., and each subsequent annual meeting of stockholders shall be held in January. . . . The January Bylaw is significant for two reasons. First, the January Bylaw substantially shortens the terms of the Airgas directors by accelerating the timing of Airgas's annual meeting. The January Bylaw would require Airgas to hold its 2011 annual meeting only four months after its 2010 meeting. That accelerated meeting date would contravene nearly two and one-half decades of Airgas practice, during which Airgas never has held its annual meeting earlier than July 28. That would also mark the first time Airgas held an annual meeting without having new fiscal year results to report to its shareholders. Additionally, if the January Bylaw is valid, Air Products need not wait a year to cause the election of another three directors to Airgas's staggered board, because the terms of the incumbent directors would be shortened by eight months. At Airgas's annual meeting on September 15, 2010, Airgas shareholders elected the three Air Products nominees to Airgas's board and adopted Air Products' proposed bylaw amendments, including the January Bylaw.12 4 Of the 73,886,665 shares voted, a bare majority -- 38,321496
10 To Class: Absent this provision in the Charter, what would the default rule be on removal of the Airgas board without cause? What about with cause? 11 [Courts footnote #2: Over the past twenty-four years, Airgas has held its annual meeting on the following dates: August 3, 1987; August 1, [*9] 1988; August 7, 1989; August 6, 1990; August 5, 1991; August 3, 1992; July 28, 1993; August 1, 1994; August 7, 1995; August 5, 1996; August 4, 1997; August 3, 1998; August 2, 1999; August 3, 2000; August 2, 2001; July 31, 2002; July 29, 2003; August 4, 2004; August 9, 2005; August 9, 2006; August 7, 2007; August 5, 2008; August 18, 2009; and September 15, 2010. 12 Court footnote 4: On September 23, 2010, Airgas expanded its board from nine to ten members, reappointing Chief Executive Officer, Peter McCausland, who lost his reelection bid at the September 15, 2010 annual meeting.

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shares, or 51.8% -- were voted in favor of the January Bylaw. But of the 83,629,731 shares that were entitled to vote, only 45.8% were voted in favor of the January Bylaw. Procedural History Airgas brought this action in the Court of Chancery, seeking a declaratory judgment that the January Bylaw is invalid. Air Products counterclaimed, seeking a declaratory judgment that the January Bylaw is valid. After a trial, the Court of Chancery rejected Airgas's claims and entered final judgment in favor of Air Products. The Court of Chancery held that the January Bylaw had been duly adopted by a majority of the voted shares, and did not conflict with the Charter. After analyzing the January Bylaw under sections 141 and 211 of the DGCL, the Court of Chancery concluded that the January Bylaw is valid under Delaware law.5 This appeal followed. ANALYSIS [The court notes that some corporations provide in their charters that each class of directors serves until the "annual meeting of stockholders to be held in the third year following the year of their election" (collectively, the "Annual Meeting Term Alternative"). Others provide in their charters that each class serves for a "term of three years (collectively, the "Defined Term Alternative"). Unlike the Annual Meeting Term Alternative, the Defined Term Alternative unambiguously provides in the charter itself that each class of directors serves for three years. The courts notes that Article 5, Section 1 of the Airgas Charter and Article III, Section 1 of its Bylaws both employ the Annual Meeting Term Alternative.] The central issue presented on this appeal is whether the Airgas Charter requires that each class of directors serves three year terms or whether it provides for a term that can expire at whatever time the annual meeting is scheduled in the third year following election. The Court of Chancery adopted the latter view without giving any weight to the uncontroverted extrinsic evidence bearing on the intended meaning of the Airgas Charter. The Court of Chancery's Analysis The Court of Chancery articulated its rationale this way: Airgas's charter provision is not crystal clear on its face. A "full term" expires at the "annual meeting" in the "third year" following a director's year of election. The absence of a definition of annual, year, or full term leads to this puzzle. Does a "full term" contemplate a durationally defined three year period as Airgas suggests? The charter does not explicitly say so. Then, if a "full term" expires at the "annual meeting," what does "annual" mean -- yearly? In turn, if "annual" means "separated by about a year," does that mean fiscal year? Calendar year? . . . The lack of a clear definition of these terms in the charter mandates my treatment of them as ambiguous terms to be viewed in the light most favorable to the stockholder franchise. Construing the ambiguous terms in that way, if the "full term" of directors does expire at the "annual meeting" in the "third year" following their year of election, I now turn to what is meant by the "annual" meeting. . . . Because this term is not otherwise defined in Airgas's charter or bylaws, I turn to the common dictionary definition, which defines "annual" as "covering the period of a year" or "occurring

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or happening every year or once a year." And again, construing the ambiguous terms of the charter in favor of the shareholder franchise, "annual" in this context must mean occurring once a year. . . .**** As such, a January 18, 2011 annual meeting would be the "2011 annual meeting." 2011 is the third "year" after 2008. Successors to the 2008 class can be elected in the "third year following the year of their election" which is 2011. Thus, the bylaw does not violate Airgas's charter as written. 12 We agree with the Court of Chancery that the relevant Charter language is ambiguous. But as more fully discussed below, there is overwhelming extrinsic evidence that under the Annual Meeting Term Alternative adopted by Airgas, a term of three years was intended. Therefore, the January Bylaw is inconsistent with Article 5, Section 1 of the Charter because it materially shortens the directors' full three year term that the Charter language requires. It is settled Delaware law that a bylaw that is inconsistent with the corporation's charter is invalid. Article 5, Section 1 of the Charter is Ambiguous To determine whether the January Bylaw is inconsistent with the Charter, we first must address Article 5, Section 1 of the Charter. Although the Annual Meeting Term Alternative employed in that section is facially ambiguous, our precedents, and the common understanding of that language enable us to interpret that provision definitively. The "context clearly requires" the interpretation we adopt, because the relevant "legal phrase [] ha[s] a special meaning," and because we "must give effect to the intent of the parties as revealed by the language of the certificate and the circumstances surrounding its creation and adoption." "If there is more than one reasonable interpretation of a disputed contract term, consideration of extrinsic evidence is required to determine the meanings the parties intended." Delaware courts often look to extrinsic evidence for the common understanding of ambiguous language whether in a statute, a rule or a contractual provision. Delaware Precedents [The court says that the Delaware Chancery Court, when interpreting similar (albeit differently worded) terms has construed similar charter language as creating a staggered board with classes of directors who serve three year terms.] The Annual Meeting Term Alternative and the Defined Term Alternative in Practice Although practice and understanding do not control the issue before us, we agree with Airgas that "[p]ractice and understanding in the real world" are relevant. Here, we find the industry practice and understanding of similar charter language to be persuasive. Of the eighty-nine Fortune 500 Delaware corporations that have staggered boards, fifty-eight corporations use the Annual Meeting Term Alternative. More important, forty-six of those fifty-eight Delaware corporations, or 79%, expressly represent in their proxy statements that their staggered-board directors serve three year terms. Indeed, Air Products itself uses the Annual Meeting Term Alternative in its charter,13 21 and represents in its proxy statement that: "Our Board is divided
13 Court footnote 21 Article 10 of Air Products' charter provides: ". . . [T]he directors chosen to succeed those whose terms are expiring shall be identified as being of the same class as the directors whom they succeed and shall be elected for a term expiring at the third succeeding annual meeting of stockholders or thereafter in each case when their respective successors are elected and qualified. . . ."

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into three classes for purposes of election, with three-year terms of office ending in successive years." 22 Also noteworthy is the practice and understanding of corporations that have "de-staggered" their boards. Ninety-nine of the Fortune 500 Delaware corporations have de-staggered their boards over the last decade. Of those ninety-nine corporations, sixty-four used the Annual Meeting Term Alternative, and an overwhelming majority -- sixty-two, or 97% -- represented in their proxy statements that their directors served three year terms. We cannot ignore this widespread corporate practice and understanding it represents. It supports a construction that the Annual Meeting Term Alternative is intended to provide that each class of directors serves three year terms. Air Products has offered no evidence to the contrary. **** 28 [The court concludes:] the Court of Chancery erred, because it failed to give proper effect to the overwhelming and uncontroverted extrinsic evidence that establishes, and persuades us, that the Annual Meeting Term Alternative and the Defined Term Alternative language mean the same thing: that each class of directors serves three year terms. No party to this case has argued that DGCL Section 141(d) or the Airgas Charter requires that the three year terms be measured with mathematical precision. 14 Nor is it necessary for us to define with exactitude the parameters of what deviation from 365 days (multiplied by 3) satisfies the Airgas Charter three year durational requirement. In this specific case, we may safely conclude that under any construction of "annual" within the intended meaning of the Airgas Charter or title 8, section 141(d) of the Delaware Code, four months does not qualify. In substance, the January Bylaw so extremely truncates the directors' term as to constitute a de facto removal that is inconsistent with the Airgas Charter. The consequence of the January Bylaw is similar to the bylaw at issue in Essential Enterprises. It serves to "frustrate the plan and purpose behind the provision for [Airgas's] staggered terms and [] it is incompatible with the pertinent language of the statute and the [Charter]." 35 Accordingly, the January Bylaw is invalid not only because it impermissibly shortens the directors' three year staggered terms as provided by Article 5, Section 1 of the Airgas Charter, but also because it amounted to a de facto removal without cause of those directors without the affirmative vote of 67% of the voting power of all shares entitled to vote, as Article 5, Section 3 of the Charter required CONCLUSION The judgment of the Court of Chancery is REVERSED.

14

We recognize that Delaware corporations have some latitude in setting the date for an annual meeting. See 8 Del. C. 211. Therefore, a director's term may properly end at an annual meeting even though that director only served approximately three years rather than exactly three years. In this case, however, we need not decide the parameters of an approximate term of three years because twenty-eight months is not approximately three years.

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Agency Costs of Equity Just like the shareholder-creditor relationship created agency costs of debt, the relationship between shareholders and directors/managers creates agency costs of equity: instead of acting in the best interest of the shareholders, the managers may pursue their own personal interests. For most of the rest of the course, we will consider the legal rules governing the shareholder-manager relationship. It will be helpful to you to start now considering in which spheres conflicts of interests between shareholders and managers are particularly strong, to what extent non-legal forces mitigate such conflicts, and whether and how legal rules can address such conflicts.

(See Dela. 109, 141, 142, 211, 212(a), 216, 223, 228, 242(b), 271 CONTROL THROUGH ELECTION OF BOARD OF DIRECTORS Assume that Patterson Corporation, a newspaper company, is a prosperous concern which is incorporated in Delaware. Alice Patterson owns 15 percent of the stock and is the firm's CEO. She also is Chairperson of the Board of Directors. The balance of the stock is widely held but Alice has successfully controlled the election of the entire board of directors over many years. Rumors, however, have been spreading that Robert Morduck is seeking to purchase 51 percent of the shares. Alice is afraid that she will not only lose voting control but that she will be cut out of management entirely. Alice is particularly nervous about this possibility because Morduck favors expansion of Patterson in the tabloid newspaper business which Alice thinks will destroy Pattersons reputation and hurt its regular daily newspaper business. Patterson Corp. has a certificate that contains the information required under Section 102, Patterson Corp's certificate of incorporation also contains the following provisions: (1) The board of directors may adopt, amend, or repeal the bylaws of the corporation. (2) Special meetings of the shareholders may be called by the CEO. The bylaws contain the following provisions: (1) The annual meeting will be held every year in September. (2) The board is composed of nine people. (3) Directors serve one-year terms.

PATTERSON PROBLEM

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Please answer the following, being sure to explain your answer (citing relevant code section(s)). (a) Are the various provisions in the certificate and the bylaws legal? (b) Who manages this firm? Can Alice ensure she manages the firm by having the shareholders adopt a bylaw which grants her the unilateral right to make all management decisions on behalf of the firm, regardless of her position within the firm, for the next 5 years. (c) Assume Robert gets 51% of the stock. At the next annual shareholder meeting may he immediately implement his business plan by passing a binding shareholder resolution providing that Patterson should purchase the National World, a tabloid magazine? If not, how does Robert, as a shareholder, effect his will? (d) If Robert does purchase 51%, can he get control of the entire board at the next annual meeting? Once he does this, can he replace Alice as CEO with someone he prefers? Key: Who has the power to elect officers? (i) Can he gain control on the facts as stated? (ii) If so, why did the Series AA holder in Crown Emak follow a different approach? What approach did they take. (e) Assume Robert obtains 51% of the stock and wants control long before the next annual meeting would normally be scheduled: Could Robert achieve this goal by calling special meeting of the shareholders to remove the entire board of directors without cause and to replace them with his own nominees. What if Alice, as CEO and Chairman of the Board of Directors, declines to call the meeting arguing that Robert has no authority to call the meeting and that the meeting is for an improper purpose? (f) Assume that Alice anticipates Roberts actions. Assume she does the following before he purchases his 51% of the shares: (i) The certificate was amended at a shareholders' meeting to provide that the power to amend the by-laws shall be vested in the directors. (ii) The by-laws were then amended by the board, and the number of directors was fixed at nine, divided into classes of three whose terms expire in successive years. (iii) At the annual meeting of shareholders the new amendments to the bylaws were ratified and nine directors were elected upon the conditions set forth in (ii). All of them are loyal to Alice What is the result of these actions if effective. Will classifying the board enable her to voice on the board in three years?

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(g) Assume that she effectively classifies the board: (i) can Robert remove the directors without cause and replace them with his own? (ii) Could he use written consent to pay a bylaw amendment to reduce the board size to one director and then replace that person at the next annual meeting? (g) If Robert purchases 51 percent of Pattersons stock, will he be able to devise some method for him to immediately assume and exercise control over company policy. Can he get the new provisions tossed out in court? On what grounds If the provision is valid, can he obtain immediate control of the board even if the provision is valid? In light of this, what must Alice do to create an effective Classified board? (h) Assume that Alice creates an effective classified board, fixes the number of directors in the Charter, and includes a provision in the Charter requiring a vote of 86% of the shareholders to remove anyone on the board without cause. Assume that the Charter also requires a vote of 86% of the shares to adopt any charter amendment or bylaw that is inconsistent with the removal provision. Now assume that Robert purchases 51% of the shares in July. Can Robert obtain immediate control of the board by nominating and electing three people to the board at the annual meeting in September while also proposing, and then adopting, a bylaw amendment that sets the date for the next annual meeting for January, enabling him in January to elect three new people to the board then. Why would he want to do this? Is it valid?

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CROWN EMAK PARTNERS v. DONALD A. KURZ et al

SUPREME COURT OF DELAWARE April 21, 2010, Decided JUDGES: Before STEELE, Chief Justice, HOLLAND, BERGER, JACOBS and RIDGELY, Justices, constituting the Court en Banc. OPINION HOLLAND, Justice: This is a consolidated appeal from a final judgment entered by the Court of Chancery pursuant to Rule 54(b). This proceeding involves competing requests for relief under section 225 of the Delaware General Corporation Law (the "DGCL"). 1 At issue is which of two competing factions lawfully controls the board of directors (the "Board") of EMAK Worldwide, Inc. ("EMAK"). Prior to December 18, 2009, the Board had six directors and one vacancy. On December 18, one director resigned, creating a second vacancy. The plaintiffs-appellees contend that on December 20 and 21, [they delivered sufficient written consents to get control] The defendants-appellants contend that on December 18, 2009, Crown EMAK Partners, LLC ("Crown") delivered sufficient consents (the "Crown Consents") to amend EMAK's bylaws (the "Bylaw Amendments") in two important ways. First, the Crown Consents purportedly amended Section 3.1 of the Bylaws ("New Section 3.1") to reduce the size of the Board to three directors. Because Crown has the right to appoint two directors under the terms of EMAK's Series AA Preferred Stock, a by-law reducing the Board to three, if valid, would give Crown a Board majority. *** [As to the validity of the bylaw] The Court of Chancery also concluded that the bylaw amendments adopted through the Crown Consents conflict with the DGCL and are void. Therefore, the court held, the Crown Consents were ineffective either to reduce the size of the Board or to require the calling of a special meeting. *** [Appellants argue that the Court of Chancery erred when it held that the Crown Consent was void because the amendments to the bylaws conflict with Delaware law. **** we hold that the Crown bylaw amendments were invalid because they conflict with Delaware law. *** Factual Background EMAK's Capital Structure EMAK is a Delaware corporation based in Los Angeles, California. EMAK has two classes of stock: common shares and the Series AA Preferred Stock. [Crown holds all the Series AA Preferred Stock] The Series AA Preferred has the right to elect two directors to the Board, plus a third director if the Board expands to more than eight members. The Series AA Preferred does not vote in the election of directors. It does vote on an as-converted basis with the common stock

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on all other matters. The Series AA Preferred can convert into 2,777,777 common shares and carries 27.6% of EMAK's total voting power on matters where it votes with the common stock. **** [Crown solicited consents to reduce the board to three members, two of which would be elected by the Series AA stock (as before). It also had a second bylaw which we wont consider] Analysis Crown Bylaw Amendments Are Invalid The Court of Chancery held that the Crown Consents are ineffective because they purported to amend the Bylaws in a manner that conflicts with the DGCL. Section 109(b) of the DGCL provides that the bylaws of a Delaware corporation "may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees." 48 Therefore, a bylaw provision that conflicts with the DGCL is void. Through the Bylaw Amendment to section 3.1, Crown tried to reduce the Board's size below the number of currently sitting directors. Generally, in a contested election, an insurgent first removes the challenged directors, then reduces the number of directorships, and then fills the vacancies.49 We hold that was the legally proper sequence for accomplishing Crown's objective in this case. Crown could not follow that approach, however, because Crown was not entitled to vote the Series AA Preferred to remove directors. Under section 141(k) of the DGCL, shares can vote to remove directors only if they can vote to elect directors. 50 The Series AA Preferred does not vote to elect directors; consequently, it cannot vote to remove directors. Section 141(b) of the DGCL provides that "[t]he number of directors shall be fixed by, or in the manner provided in, the bylaws, unless the certificate of incorporation fixes the number of directors, in which case a change in the number of directors shall be made only by amendment of the certificate." 51 The EMAK charter does not fix the number of directors, which instead is addressed in Section 3.1 of the Bylaws. Therefore, the defendants correctly assert that stockholders exercising a majority of EMAK's outstanding voting power, including the Series AA Preferred, can alter the size of the Board through a bylaw amendment. The DGCL addresses what happens with the newly-created directorships where the size of the board is increased. Under section 223(a)(1), unless otherwise specified in the certificate of incorporation or bylaws, "newly created directorships resulting from any increase in the authorized number of directors elected by all of the stockholders having the right to vote as a single class may be filled by a majority of the directors then in office, although less than a quorum." 52 Although EMAK's charter is silent on this point, Section 3.2 of its Bylaws provides that the Board may fill newly created directorships. Under Delaware case law, newly created directorships also may be filled by the stockholders. 53 The Court of Chancery recognized that this case -- involving a reduction in the size of the board -- presented an issue of first impression:

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Our law has not addressed what happens when a bylaw amendment would shrink the number of board seats below the number of sitting directors. The DGCL does not address it. No Delaware court has considered it. None of the leading treatises on Delaware law mention it. 54 Indeed, no one seems to have contemplated it. New Section 3.1 would reduce the Board to three directorships at a time when five directors are legally in office. The Court of Chancery identified two possible scenarios for the resulting "surplus directors." One is that their terms would end. The other is that they would continue to serve without de jure official status, until their terms were ended by a statutorily recognized method. The Court of Chancery held that both possible scenarios conflict with the DGCL. We agree. First, the Court of Chancery concluded that the scenario in which the terms of the extra directors would end conflicts with section 141(b)'s mandate that "[e]ach director shall hold office until such director's successor is elected and qualified or until such director's earlier resignation or removal." 55 Section 141(b) recognizes three procedural methods by which the term of a sitting director can be brought to a close: first, where the director's successor is elected and qualified; second, if the director resigns, or third; if the director is removed. Section 141(b) does not contemplate that a director's term can end through board shrinkage. Accordingly, the Court of Chancery properly held that a bylaw that seeks to achieve this result conflicts with section 141(b) and is void. The Court of Chancery also held that the presence of directors without board seats would create a conflict between the number of directors in office and the number of directors provided for in the bylaws. Section 141(b) states that "[t]he number of directors shall be fixed by, or in the manner provided in, the bylaws, unless the certificate of incorporation fixes the number of directors." 56 Section 141(b) does not contemplate a board with more directors serving than the "number . . . fixed by . . . the bylaws." New Section 3.1 fixed the number of EMAK directors at three. If the excess directors are not eliminated, then for some period of time, EMAK will have a greater number of directors serving than the number for which the Bylaws provide. Such an occurrence is contrary to section 141(b) and, therefore, the Court of Chancery properly concluded, is not legally possible. The Court of Chancery held that the existence of more incumbent directors than there are board seats also conflicts with the statutory quorum requirement for board action. Section 141(b) provides: A majority of the total number of directors shall constitute a quorum for the transaction of business unless the certificate of incorporation or the bylaws require a greater number. Unless the certificate of incorporation provides otherwise, the bylaws may provide that a number less than a majority shall constitute a quorum which in no case shall be less than 1/3 of the total number of directors except that when a board of 1 director is authorized under this section, then 1 director shall constitute a quorum. 57 "[T]he universal construction" of the above-quoted language has been that it "refers to directorships, not directors actually in office." 58 The Court of Chancery explained why quorum requirements would be impossible to apply if the number of directors could exceed the number of directorships:

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Start with the statutory minimum quorum of "1/3 of the total number of directors" and envision a bylaw amendment that converted a board of twelve directors into a board of three directorships, with nine continuing but seatless directors. A single director could satisfy the statutory one-third quorum requirement, despite twelve directors serving on the board. EMAK has a majority quorum requirement. If the Bylaw Amendments turned two of the directors into continuing but seatless directors, then a quorum would be two out of three seats. Yet there would be five directors in office. The concept of continuing but seatless directors thus conflicts with section 141(b)'s mechanism for determining a quorum. Once again, the Bylaw Amendments are void. The Court of Chancery held that new Bylaw Section 3.1.1 conflicts with the statutory framework of the DGCL by conflating what takes place at an annual meeting with what can take place in between annual meetings. The DGCL establishes an annual electoral cycle for directors who are not elected by the holders of a particular class or series of stock. 59 Except in the case of a properly classified board, the occupants of all directorships contemplated by the corporation's charter and bylaws are up for annual election. 60 Pursuant to this statutory framework, "absent a specific charter or bylaw provision classifying a board, the term of office of each director is coextensive with the period between annual meetings." 61 Section 211(b) distinguishes between stockholder action at an annual meeting and stockholder action between annual meetings. Section 211(b) provides that stockholders can take action by written consent to elect directors in lieu of an annual meeting if (i) the action by consent is unanimous or (ii) "all of the directorships to which directors could be elected at an annual meeting held at the effective time of such action are vacant and are filled by such action."62 In this case, the action by consent was not unanimous and there were no vacant directorships. To operate in lieu of an annual meeting, a non-unanimous written consent thus must first remove all sitting directors and then fill the resulting vacancies. Stockholders cannot use a non-unanimous written consent to remove lawfully serving incumbent directors, and then elect successor directors, between annual meetings. ***** New Section 3.1.1 provides that if the number of directors in office is greater than three, then a special meeting of stockholders will be called at which "one director" will be elected by the common stockholders "who shall be the successor to all directors previously elected by the common stockholders of the Corporation." The Court of Chancery opined that: If the number of seats on the board was reduced in conjunction with the election of directors at an annual meeting such that only one seat was up for election, then this mechanism would be valid. In that scenario, stockholders would elect directors to all available seats, albeit only one, and the terms of the previously serving directors would expire in conjunction with the election and qualification of their singular successor. New Section 3.1.1, however, does not propose to alter the Board's size in conjunction with an annual meeting. It contemplates the calling of a special meeting at which stockholders would act to elect a "successor" director. The election of successors takes place at an annual meeting, not between annual meetings. Stockholders can act in between annual meetings to remove directors, to fill vacancies, or to fill newly created directorships. 63 They cannot end an incumbent director's

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term prematurely by purporting to elect the director's successor before the incumbent's term expires. As the Court of [**68] Chancery explained "[p]ermitting such action would contradict the limited and enumerated means in which a director's term can end under Section 141(b), the specific mechanism for director removal set forth in Section 141(k), and the concept of an annual meeting at which directors are elected under Section 211(b)." Accordingly, the Court of Chancery properly held that new section 3.1.1 is also invalid. Conclusion The judgments of the Court of Chancery are affirmed in part and reversed in part. This matter is remanded for further proceedings in accordance with this opinion. The mandate shall issue immediately.

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A Big Bet on Zuckerberg

By STEVEN M. DAVIDOFF Buying Facebook is really a bet on Mark Zuckerberg. Yes, we all know he is Facebooks twenty-something visionary founder, as well as the person who has led Facebook to a potential market value of $75 billion to $100 billion. But there is another reason an investment in Facebook is really an investment in Mr. Zuckerberg: Facebooks offering documents show he will retain control over Facebook even when it becomes one of Americas largest publicly traded companies. Mr. Zuckerbergs control is based on the structure of Facebooks shares. Facebook is proposing to go public with a dual-class share structure. Public shareholders will purchase Class A shares that have one vote apiece. Mr. Zuckerberg, Facebook employees and current Facebook investors will hold Class B shares, which have 10 votes apiece. This is a deviation from the one share one vote norm followed by most publicly traded companies. Eight years after the companys founding, Mr. Zuckerberg has retained a remarkable percentage of Facebooks ownership he currently owns 28.4 percent of the Class B shares. This alone does not give Mr. Zuckerberg total control over Facebook. He has also entered into voting agreements with other Class B shareholders, including shares held by the Facebook co-founder Dustin Moskovitz and Facebooks first president, Sean Parker. These agreements give Mr. Zuckerberg voting control over an additional 30.6 percent of the Class B shares. Mr. Zuckerberg even retains control over about half of these shares if he decides to leave Facebook. Post-I.P.O., he will control at least 57.1 percent of the Class B shares, potentially more if some investors sell their B shares in the offering. This will give him complete voting control over the company. Mr. Zuckerbergs consent will be required if the company is sold. Unlike most public companies, Facebook will not have a nominating committee for its directors comprising the independent directors on Facebooks board. Instead, all of the directors will be selected by the board itself, a group that will be appointed by Mr. Zuckerberg. He can also remove and replace any director at any time. Nor is this going to change any time soon. Facebooks organizing documents dictate that when Class B shares are transferred, they typically will convert into the low-vote Class A shares. It is likely that, over time, Mr. Zuckerberg will hold onto the bulk of his Class B shares as other holders of Class B shares sell off their stakes. This is the rub of the dual-class shares.

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Mr. Zuckerberg can also sell down his shares. But until the Class B shares comprise less than 9.1 percent of the outstanding Facebook shares, the holders of the Class B shares control Facebook. Given this low threshold, Mr. Zuckerberg, 27, is likely to have enough Class B shares to give him control of the company for a long, long time, despite the fact that he will have a much smaller economic stake. In fact, other shareholders are more likely to sell their Class B shares more quickly than Mr. Zuckerberg, who appears to want to manage Facebook for the long-term. As a result, his control over Facebook could increase over time. Mr. Zuckerberg is not alone in using this type of structure to maintain ownership of a prominent technology company. The founders of Google, Larry Page and Sergey Brin, set up a similar structure and retain voting control over Google. Yet they are two people who counterbalance each other, not a single individual. Three other prominent company founders, Andrew Mason at Groupon, Mark Pincus at Zynga and Reid Hoffman at LinkedIn, have also adopted similar dual-class voting structures at their companies. At the time of those public offerings last year, Mr. Mason controlled 19.7 percent of the votes at Groupon, Mr. Pincus controlled 37.4 percent of the votes at Zynga and Mr. Hoffman controlled 21.7 percent of the votes at LinkedIn. These companies, however, are much smaller than Facebook. And while their stakes are sizable, they do not entitle any of the three founders to remove and replace directors at will. Even Bill Gates had less than 50 percent control over Microsoft at the time of its I.P.O. he owned 49 percent of the company. Since he did not own dual-class shares, any sales by him were sure to reduce his controlling interest. Mr. Zuckerberg thus stands alone in exercising this degree of control over a very public technology company. As DealBooks Evelyn M. Rusli and Peter Eavis have reported, Facebook could be valued more richly than Amazon, Kraft Foods and Goldman Sachs. In essence, Mr. Zuckerberg has created an empire that he will continue to rule. This is not necessarily a bad thing. He is young, but he has already accomplished more than most of us will in our lives. He is the guiding force behind Facebook. Mr. Zuckerberg had the foresight to obtain these voting agreements, arrangements which now ensure he will control the company for a substantial amount of time. By maintaining control, Mr. Zuckerberg no doubt hopes to continue to implement his vision free from intrusive shareholder influence. He is about to get his wish. As for the public, whether they buy Facebook shares boils down to whether they believe in Mr. Zuckerberg and the control he will wield.

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Note on Cumulative Voting (skim) 1. Straight Voting and Cumulative Voting. In the normal case what is sometimes called a straight voting regime a shareholder can cast, for each candidate for election to the board, a number of shareholders equal to her number of shares. For example, assume that shareholder S owes 100 shares in Blue Corporation, that Blues board consists of seven directors, and that all seven directorship positions are up for election. Under straight voting, S can case a total of 700 votes, but cannot cast more than 100 votes for any one candidate. In contrast, under a cumulative-voting regime a shareholder can case for any single candidate, or for two or more candidates, as she chooses, a number of votes equal to the number of share she holds time the number of directors to be elected. This in the Blue corporation example, under cumulative voting S can cast 700 votes for one candidate, or 350 votes for each of two candidates, or 300 shares for each of two candidates and 100 shares for a third candidate, and so forth. Under straight voting, a minority shareholder or faction can never elect a director to the board over the opposition of the majority. For example, suppose that Blue corporation has 300 shares, 100 of which are held by S, and 200 of which are held by T. Recall that Blue has seven directors, all of which are up for election. Under straight voting, S can cast no more than 100 votes for any of her candidates. Since T can cast 200 votes for each of his seven candidates, T can elect all the directors. In contrast, if cumulative voting is in effect, S can distribute her 700 votes among one or more candidates. Similarly, T can cast a total of 1400 votes, which he can distribute among one or more candidates. Suppose that S casts 350 votes for each of two candidates. If T distributes his 1400 votes among seven candidates, each of his candidates will receive 200 votes. Accordingly, S will elect her two candidates, because they will each receive more votes (350) than any of Ts candidates (200). T will elect five candidates. Suppose that T casts 351 votes for each of two candidates. In that case, T can cast only 698 votes for his other five candidates. Since some of Ts candidates will therefore receive less than 350 votes, S will still elect her two candidates to the board. 2. Mathematics, Aranow & Einhorn, Proxy Contests for Corporate Control 10.04 [B] (3rd ed. 1998) discusses the mathematics of cumulative voting, as follows: The mathematics of cumulative voting can become a very involved subject which we will not undertake to discuss in all its aspects. These are two basic formulas both of which are relatively simple. The first formula is used to determine the minimum numbers of shares needed to elect a particular number of directors: If there are only whole shares, does this mean that the minority group needs 201 to elect two directors, or 202 shares? The answer is, surprisingly, 201if the standard formula does not yield a whole number you must round down to determine

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the number of whole shares needed. X = (S x N) + 1 D+1 X = minimum number of shares needed S = total of shares that will be voted at meeting N = number of directors desired to elect D = total number of directors to be elected For example, assume there exists a corporation with 1,000 share outstanding and seven directors to be elected. A minority stockholders group wishes to elect two directors. It is estimated that 800 shares will be voted at the meeting. Applying these figures to the formula, the resulting calculation is: (800 x 2) + 1 = 200 7+1 The stockholders group knows that it must have ownership or control of at least 20 1 shares in order to elect two directors. The second formula can be used to determine how many director can be elected by a group controlling a particular number of shares. N = (X) x (D + 1) S N = number of director that can be elected X = number of shares controlled D = total number of directors to be elected S = total number of shares that will be voted at meeting In the example above, assume that the stockholders group knows it will control 201 shares. Applying the figures to this formula, the resulting calculation is: 201 x 8 = 2.01 800 Thus, cumulation will result in the election of two directors. There are several other formulas that can be applied to more complicated questions. Jesse Fried points out that: The standard formula for determining the minimum number of shares

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necessary to elect a particular number of directors yields an easily interpretable result only when the expressions (S x N) (D + 1) is a whole number. Suppose, as in the Aranow and Einhorn example, that there is a corporation with seven directors to be elected and a minority group wishes to elect two directors. However, 803 shares (rather than the 800 shares used in their example) will be voted a the meeting. The standard formula indicates that the number of shares need to elect two directors is now: [(803 x 2) (7 + 1)] +1 = 201.73 A more useful formula for determining the minimum number of shares needed (X), is X> (SxN)/(D +1) If there are fractional shares, then any fraction greater than the righthandside expression will allow you to elect N directors. If there are whole shares, then you round up to the next whole number. 3. Mandatory Cumulative Voting. The percentage of stock that minority shareholders must hold to elect at least one director under cumulative voting varies inversely with the number of directors to be elected. Accordingly, a 12% minority (for example) can elect one director if nine directors are to be elected, but cannot elect any directors if three directors are to be elected. This can give rise to various problems when cumulative voting is mandatory. One problem is whether, when cumulative voting is mandatory, a corporation can have a classified board, in which the directors are divided into classes and each class serves for a term of years. Where a board is classified the minority must hold more stock, to elect a single director, than if a board of the same size was unclassified. In Wolfson v. Avery, 6 Ill.2d, 126 N.E>2d 701 (1955), the Illinois court held that an Illinois constitutional requirement of cumulative voting prohibited classified boards. The Illinois Constitution was later amended to eliminate this requirement. In Bohannan v. Corporation Commission, 82 Ariz. 299, 313 P.2d 379 (1957), the Arizona court held to the contrary. (Subsequently, the Arizona legislature enacted a statutory provision that permitted classification if a board had nine or more directors.) Still another issue concerns the removal of directors, Cumulative voting could be undercut if a director who is elected by a minority under cumulative voting could then be removed by majority. Accordingly, some statutes provide that under cumulative voting, a director cannot be removed if the number of shares voting against her removal would be sufficient to elect her. See, e.g. Cal.Corp. Code 303(a)(1).

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The Business Judgement Rule, Fiduciary Duties, and Shareholder Suits

The allocation of the central management function to the directors, and through them to the officers, gives the managers of a corporation significant power. Directors and officers are, of course, subject to fiduciary duties. Shareholders, by and large, are the parties who benefit from fiduciary duties and who generally seek to enforce them. Yet, as a legal matter, fiduciary duties are often conceptualized as running to the corporation in the first instance. As a practical matter, courts must take care to define and enforce fiduciary duties in ways that do not trench too deeply on the discretion of the board of directors to manage the company. The legal doctrine that serves to insulate the board of directors from shareholder suits is the "business judgment rule". The business judgment rule defines the (rather broad) set of circumstances in which courts will refuse to second-guess decisions by the board of directors. Thus, within this set of circumstances, decisions by the directors are "protected" by the business judgement rule from shareholder attack. Only if the business judgement rule does not apply will courts examine the actions of the directors more closely to determine whether there has been a breach of fiduciary duties. Another distinctive feature of fiduciary doctrine in the corporate context is institutional: In a typical public corporation there may be thousands or even tens of thousands of shareholders. These shareholders would have no incentive to bear the costs of bringing suit to enforce the fiduciary duties of officers and directors without highly specialized legal regimes designed to overcome the shareholders' collective action problem (i.e., the fact that a single shareholder qua shareholder stands to gain only a tiny fraction of the benefit that a meritorious suit might confer on all shareholders). Most jurisdictions outside the United States experience relatively little litigation by shareholders against corporate officers and directors precisely because of this collective action problem. It only makes economic sense for very large shareholders to sue, even where shareholders have a formal right of action. By contrast, in U.S. jurisdictions, shareholders can recover generous compensation for legal costs (if their suits succeed) by framing their suits either as shareholder derivative actions (suits brought on behalf of the corporation) or as shareholder class actions. As a consequence, there are powerful incentives for small shareholders to bring suit, and -notwithstanding the business judgment rule -- fiduciary law helps to support an extremely active plaintiff's bar that searches energetically for new opportunities to bring suit. The net result of this coupling of fiduciary doctrine to a "bounty-hunter" system of private enforcement is to create a legal regime that is in constant flux. Particularly during the 1980s, both substantive fiduciary doctrine and procedural rules governing derivative suits were revised to give more insulation to corporate officers and directors. At the same time, larger recoveries and settlements stimulated more shareholder lawsuits alleging breach of fiduciary duties, particularly in the context of mergers, acquisitions, and similar "control transactions." Despite all this action, however, we have made little progress on the basic questions: definitively framing fiduciary doctrines, or finding satisfactory methods of regulating the level of shareholder enforcement.

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QUESTIONS ON KAMIN 1. What is a derivative suit? What is an individual shareholder suit? Who gets the damages in each? (Answer: See Klein & Coffee 207-211) 2. Kamin: Who are the defendants? Is the firm a defendant? To whom do the damages go? 3. Why is plaintiff upset with the directors' decision to distribute the shares as a dividend? What does he think was wrong with this decision? 4. As to the directors claim that it is a good decision, what value do you think the securities markets attached to the shares of DLJ that American Express held: the original purchase value or the current market price. 5. The directors probably did make a bad business decision. Given this, why does P. lose? Why does the court say that this was NOT a duty of care case when the directors arguably made a bad decision? 6. What, if any, is the justification for the Business Judgment Rule? It is often said that business decisions are complex and thus juries are not able to determine negligence. This may be true, but the business context is not the only area where decisions are complicated and require expert analysis. Another area where this holds is medical malpractice, and yet the tort system is able to determine liability. Moreover, empirical analysis suggests that the system imposes liability correctly in the vast majority of cases (75-80%). How does the tort system address complex cases like medical malpractice where juries lack expertise? Would a similar approach work for business decisions? Are there additional concerns associated with the business context that distinguish it from medical malpractice? Do shareholders have additional ways of addressing the concerns of director negligence or self-dealing not available to patients in the medical malpractice context.

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NOTES ON VAN GORKAM In order to understand this case you must go through the facts carefully. This means you must know the relevant terms. This note is meant to help you when you go through the fact. Publicly traded diversified holding company: Publicly traded means simply that its shares are traded publicly on a national exchange, rather than being privately held. Holding company is a firm whose primary purpose is to own shares of other firms. Investment Tax Credits and Accelerated Depreciation: Firms must pay taxes on the profits they earn. However, they can deduct expenses. When a firm buys a capital asset such as a rail car it cannot expense the entire cost in the year it purchases the car. Rather, it may deduct only the amount that the car depreciates in value over the year. For example, in theory if the car is likely to last 20 years, the firm might only be able to deduct 1/20th of the full value in a year. The tax code, however, provides for accelerated depreciation -- letting firms take deductions for depreciation that probably exceed the amount that the asset actually depreciated during the period. The code also allows for investment tax credits, which allows a firm to reduce actual taxes owed by a certain amount if its made certain investments. The problem is that a firm can only get the advantage of these breaks to the extent it has tax liability. Leveraged Buy-Out: Purchase of the firm (generally its shares) financed by a small amount of equity and a large amount of debt. Often after the purchase the assets of the firm are sold off to pay down the debt. Management Buy-Out: The firm's existing management buys the firm (usually through a leveraged buy out). Merger: Two firms are combined into a single firm. This is to be distinguished from a takeover where one firm (P) buys the shares of the other firm (S) and becomes its parent. In a merger, P and S become a single firm with one group of shareholders owning the combined firms. Cash Out Merger: A merger in which the shareholders of one firm (here Transunion) get cash for their shares and do not become shareholders of the new combined firm. Proprietary Information: Publicly held firms must publish vast amounts of information about themselves. They also have a considerable amount of private information, however -information that would be very very valuable to a bidder in determining what would be a good price to bid. This information is referred to a proprietary information. Fairness Opinion: Firms will ask for an opinion from investment bankers as to whether the price being offered is a fair price for the firm. Questions 1. Stalking Horse for an Auction Contest: What does Pritzker mean by this?

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2. Why does Pritzker want the option to buy one million shares for $38? Why is this referred to as a lock-up? (Why do you think he wants the deal done before the London stock market opens). 3. Why is the price per share based on the maximum share price that could sustain a leveraged buyout (Roman's estimate) not the correct estimate of the value of the firm? 4. Why is the existing market price not the correct estimate of the value of the firm? 5. Why can't the board rely on their long history with the firm to estimate the correct price? 6. Why can't the board rely on the fact that Van G. was willing to accept this price for his own shares. Wouldn't he have an incentive to get the highest price possible? Why is the court suspicious? 7. In evaluating the board's decision to enter into this deal, the board argued the court should focus on the information the board had when it made its final decision to approve the merger and send the deal on to shareholders. Did the court accept this argument? Why/why not? What date did the court focus on? Why was this significant? 8. In the sale of the firm context, what is the board of directors' duty? 9. Why didn't the market test cure any problems? 10. Did the approval by the shareholders cure the problem? What does the court say is the effect of a fully informed vote of the shareholders? 11. Read Dela 102(b)(7). What result if the firm has such a provision?

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Cinerama, Inc. v. Technicolor, Inc.

663 A.2d 1156 (Del. 1995)

The business judgment rule "operates as both a procedural guide for litigants and a substantive rule of law." As a procedural guide the business judgment presumption is a rule of evidence that places the initial burden of proof on the plaintiff. In Cede II, this Court described the rule's evidentiary, or procedural, operation as follows: If a shareholder plaintiff fails to meet this evidentiary burden, the business-judgment rule attaches to protect corporate officers and directors and the decisions they make, and our courts will not second-guess these business judgments. ... If the rule is rebutted, the burden shifts to the defendant directors, the proponents of the challenged transaction, to prove to the trier of fact the "entire fairness" of the transaction to the shareholder plaintiff. Cede II, 634 A.2d at 361. Burden shifting does not create per se liability on the part of the directors. Rather, it "is a procedure by which Delaware courts of equity determine under what standard of review director liability is to be judged." Where, as in this case, the presumption of the business judgment rule has been rebutted, the board of directors' action is examined under the entire fairness standard. This Court has described the dual aspects of entire fairness, as follows: The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. The latter aspect of fairness relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company's stock. . . . However, the test for fairness is not a bifurcated on as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness. Weinberger v. UOP, Inc., 457 A.2d at 711. Thus, the entire fairness standard requires the board of directors to establish "to the court's satisfaction that the transaction was the product of both fair dealing and fair price." ... Because the decision that the procedural presumption of the business judgment rule has been rebutted does not establish substantive liability under the entire fairness standard, such a ruling does not necessarily present an insurmountable obstacle for a board of directors to overcome. ... To avoid substantive liability, notwithstanding the quantum of adverse evidence that has defeated the business judgment rule's protective procedural presumption, the board will have to demonstrate entire fairness by presenting evidence of the cumulative manner by which it otherwise discharged all of its fiduciary duties. Although the procedural decision to shift the evidentiary burden to the board of directors to show entire fairness does not create liability per se, the aspect of fair dealing to which Weinberger devoted the most attention -- disclosure -- has a unique position in a substantive entire fairness analysis. A combination of the fiduciary duties of care and loyalty gives rise to the requirement that "a director disclose to shareholders all material facts bearing upon a ... vote . . . ." [I]n Delaware, "existing law and policy have evolved into a virtual per se rule of [awarding] damages for breach of the fiduciary duty of disclosure."

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GANTLER v. STEPHENS (Dela S Ct en banc) [footnotes omitted] JACOBS, Justice. The plaintiffs in this breach of fiduciary duty action, who are certain shareholders of First Niles Financial, Inc. (First Niles or the Company), appeal from the dismissal of their complaint by the Court of Chancery. ... In late 2003, First Niles was operating in a depressed local economy, with little to no growth in the Bank's assets and anticipated low growth for the future. At that time Stephens, who was Chairman, President, CEO and founder of First Niles and the Bank, was beyond retirement age and there was no heir apparent among the Company's officers. The acquisition market for banks like Home Federal was brisk, however, and First Niles was thought to be an excellent acquisition for another financial institution. Accordingly, the First Niles Board sought advice on strategic opportunities available to the Company, and in August 2004, decided that First Niles should put itself up for sale (the Sales Process). After authorizing the sale of the Company, the First Niles Board specially retained an investment bank, Keefe, Bruyette & Woods (the Financial Advisor), and a law firm, Silver, Freedman & Taft (Legal Counsel). At the next Board meeting in September 2004, Management advocated abandoning the Sales Process in favor of a proposal to privatize the Company. Under Management's proposal, First Niles would delist its shares from the NASDAQ SmallCap Market, convert the Bank from a federally chartered to a state chartered bank, and reincorporate in Maryland. The Board did not act on that proposal, and the Sales Process continued.In December 2004, three potential purchasers-Farmers National Banc Corp. (Farmers), Cortland Bancorp (Cortland), and First Place Financial Corp. (First Place)-sent bid letters to Stephens. ... The Board considered these bids at its next regularly scheduled meeting in December 2004. At that meeting the Financial Advisor opined that all three bids were within the range suggested by its financial models ... The Board took no action at that time. Thereafter, at that same meeting, Stephens also discussed in further detail Management's proposed privatization. ... On March 8, First Place increased the exchange ratio of its offer to provide an implied value of $17.37 per First Niles share. At the March 9 special Board meeting, Stephens distributed a memorandum from the Financial Advisor describing First Place's revised offer in positive terms. Without any discussion or deliberation, however, the Board voted 4 to 1 to reject that offer, with only Gantler voting to accept it. ... Five weeks later, on April 18, 2005, Stephens circulated to the Board members a document describing a proposed privatization of First Niles (Privatization Proposal). That Proposal recommended reclassifying the shares of holders of 300 or fewer shares of First Niles common stock into a new issue of Series A Preferred Stock on a one-to-one basis (the Reclassification). The Series A Preferred Stock would pay higher dividends and have the same liquidation rights as the common stock, but the Preferred holders would lose all voting rights except in the event of a proposed sale of the Company. The Privatization Proposal claimed that the Reclassification was the best method to privatize the Company because it allowed maximum flexibility for future capital management activities, such as open market purchases and negotiated buy-backs. ...

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On June 5, 2006, the Board determined, based on the advice of Management and First Niles' general counsel, that the Reclassification was fair both to the First Niles shareholders who would receive newly issued Series A Preferred Stock, and to those shareholders who would continue to hold First Niles common stock. On June 19, the Board voted unanimously to amend the Company's certificate of incorporation to reclassify the shares held by owners of 300 or fewer shares of common stock into shares of Series A Preferred Stock that would have the features and terms described in the Privatization Proposal. ... The Company's shareholders approved the Reclassification on December 14, 2006. ... [T]he trial court concluded that of the 1,384,533 shares outstanding and eligible to vote, 793,092 shares (or 57.3%) were voted in favor and 11,060 shares abstained. Of the unaffiliated shares, however, the proposal passed by a bare 50.28% majority vote. ... E. Procedural History The amended complaint asserts three separate claims. Count I alleges that the defendants breached their fiduciary duties to the First Niles shareholders by rejecting the First Place merger offer and abandoning the Sales Process. Count II alleges that the defendants breached their fiduciary duty of disclosure by disseminating a materially false and misleading Reclassification Proxy. Count III alleges that the defendants breached their fiduciary duties by effecting the Reclassification. The defendants moved to dismiss the complaint in its entirety. Defendants argued that Counts I and III were legally deficient for failure to allege facts sufficient to overcome the business judgment presumption; that Count II failed to state a claim that the Reclassification Proxy was materially false and misleading; and that Count III should also be dismissed because the First Niles shareholders had "ratified" the Board's decision to reclassify the First Niles shares.FN6 The Court of Chancery credited these arguments and dismissed the complaint. This appeal followed. **** I. The Court of Chancery Erroneously Dismissed Count I of the Complaint Count I of the complaint alleges that the defendants breached their duties of loyalty and care as directors and officers of First Niles by abandoning the Sales Process. Specifically, plaintiffs claim that the defendants improperly: (1) sabotaged the due diligence aspect of the Sales Process, (2) rejected the First Place offer, and (3) terminated the Sales Process, all for the purpose of retaining the benefits of continued incumbency. In his opinion, the Vice Chancellor concluded that UnocalFN11 did not apply, because the complaint did not allege any "defensive" action by the Board.FN12 The court also determined entire fairness review to be inappropriate, because (1) it would be problematic to determine "fair price" without a completed transaction, (2) the Board had not interposed itself between the shareholders and a potential acquirer by implementing defensive measures, and (3) entire fairness review would be inconsistent with the broad power allocated to directors. **** We conclude that the Court of Chancery erroneously dismissed Count I of the complaint for the reasons next discussed.

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[Ed: I have included the next part on Unocal because it will be relevant at the end of the course when we do takeovers. Please re-read it then] A. The Court of Chancery Properly Refused to Apply Unocal Scrutiny The plaintiffs first challenge the Vice Chancellor's determination that Count I was not subject to review under Unocal. We agree with that ruling and find no error. "Enhanced judicial scrutiny under Unocal applies 'whenever the record reflects that a board of directors took defensive measures in response to a perceived threat to corporate policy and effectiveness which touches on issues of control.' " The plaintiffs argue that Unocal should apply because Count I alleges that the defendants rejected a value-maximizing bid in favor of a transaction that favored their self-interest at the shareholders' expense. Stated differently, plaintiffs argue that Count I, fairly read, alleges that the defendants stood to lose the benefits of corporate control if the Company were sold, and that they therefore took defensive action by sabotaging the due diligence process, rejecting the First Place offer, and terminating the Sales Process. The Court of Chancery properly refused to apply Unocal in this fashion. The premise of Unocal is "that the transaction at issue was defensive." Count I sounds in disloyalty, not improper defensive conduct. Count I does not allege any hostile takeover attempt or similar threatened external action from which it could reasonably be inferred that the defendants acted "defensively." **** III. The Court of Chancery Erroneously Dismissed Count III of the Complaint [The complaint alleges] that the defendants breached their duty of loyalty by recommending the Reclassification Proposal to the shareholders for purely self-interested reasons (to enlarge their ability to engage in stock buy-backs and to trigger their ESOP put and appraisal rights). The Court of Chancery ... concluded that the complaint sufficiently alleged that a majority of the directors that approved the Reclassification Proposal lacked independence. Despite having so concluded, the court dismissed the claim on the ground that a disinterested majority of the shareholders had ratified the Reclassification by voting to approve it. ... We conclude that the Court of Chancery legally erred in upholding Count III on shareholder ratification grounds, for two reasons. First, because a shareholder vote was required to amend the certificate of incorporation, that approving vote could not also operate to "ratify" the challenged conduct of the interested directors. Second, the adjudicated cognizable claim that the Reclassification Proxy contained a material misrepresentation, eliminates an essential predicate for applying the doctrine, namely, that the shareholder vote was fully informed. A. The Doctrine of Shareholder Ratification Under current Delaware case law, the scope and effect of the common law doctrine of shareholder ratification is unclear, making it difficult to apply that doctrine in a coherent manner. As the Court of Chancery has noted in In re Wheelabrator Technologies, Inc., Shareholders Litigation: [The doctrine of ratification] might be thought to lack coherence because the decisions addressing the effect of shareholder ratification have fragmented that subject into three

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distinct compartments, ... In its classic ... form, shareholder ratification describes the situation where shareholders approve board action that, legally speaking, could be accomplished without any shareholder approval.... [C]lassic ratification involves the voluntary addition of an independent layer of shareholder approval in circumstances where shareholder approval is not legally required. But shareholder ratification has also been used to describe the effect of an informed shareholder vote that was statutorily required for the transaction to have legal existence.... That [the Delaware courts] have used the same term is such highly diverse sets of factual circumstances, without regard to their possible functional differences, suggests that shareholder ratification has now acquired an expanded meaning intended to describe any approval of challenged board action by a fully informed vote of shareholders, irrespective of whether that shareholder vote is legally required for the transaction to attain legal existence. To restore coherence and clarity to this area of our law, we hold that the scope of the shareholder ratification doctrine must be limited to its so-called classic form; that is, to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective. Moreover, the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve. With one exception, the cleansing effect of such a ratifying shareholder vote is to subject the challenged director action to business judgment review, as opposed to extinguishing the claim altogether (i.e., obviating all judicial review of the challenged action).15 The Court of Chancery held that although Count III of the complaint pled facts establishing that the Reclassification Proposal was an interested transaction not entitled to business judgment protection, the shareholders' fully informed vote ratifying that Proposal reinstated the business judgment presumption. That ruling was legally erroneous... [T]he ratification doctrine does not apply to transactions where shareholder approval is statutorily required. Here, the Reclassification could not become legally effective without a statutorily mandated shareholder vote approving the amendment to First Niles' certificate of incorporation.

**********
To the extent that Smith v. Van Gorkom holds otherwise, it is overruled. 488 A.2d 858, 889-90 (Del.1985). The only species of claim that shareholder ratification can validly extinguish is a claim that the directors lacked the authority to take action that was later ratified. Nothing herein should be read as altering the well-established principle that void acts such as fraud, gift, waste and ultra vires acts cannot be ratified by a less than unanimous shareholder vote. See Michelson v. Duncan, 407 A.2d 211, 219 (Del.1979) ([W]here a claim of gift or waste of assets, fraud or [u]ltra vires is asserted that a less than unanimous shareholder ratification is not a full defense.); see also Harbor Fin. Partners v. Huizenga, 751 A.2d 879, 896 (Del.Ch.1999) (explaining that ultra vires, fraud, and gift or waste of corporate assets are void acts that cannot be ratified by less than unanimous shareholder consent.) accord Solomon v. Armstrong, 747 A.2d at 1115. Voidable acts are those beyond management's powers, but where they are performed in the best interests of the corporation they may be ratified by a majority vote of disinterested shareholders. See Michelson, 407 A.2d at 219. To avoid confusion about the doctrinal clarifications set forth in Part III A of this Opinion, we note that they apply only to the common law doctrine of shareholder ratification. They are not intended to affect or alter our jurisprudence governing the effect of an approving vote of disinterested shareholders under 8 Del. C. 144.
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[Ed: The court in Gantler also held, for the first time, that corporate officers owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as those of directors. In the case the plaintiff alleged that defendant officers were responsible for preparing diligence materials for three bidders interested in their firm and did not initially provide those materials to the second bidder. The complaint alleged that one bidder withdrew because the officer never responded to a due diligence request. The Delaware Changer court held that this claim could survive a motion to dismiss because the claim supported a reasonable inference that the officers attempted to sabotage the due diligence process in breach of their fiduciary duties.] Questions on Gantler 1. The notion that any shareholders ratification must be explicit, and be made through a separate vote, seems appealing. But on the other hand, why should shareholders be able to claim damages from a transaction that they voted in favor of (assuming they were fully informed and their vote was uncoerced)? Could one argue that, while the shareholder vote did not ratify the breach of fiduciary duties for shareholders as a whole, those shareholders that did approve the transaction cannot claim damages? 2. The court holds that the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve. What does this mean? Consider the Lewis v. Vogelstein case discussed in KRB. Does the shareholder vote on the stock option plan (which was not legally required under Delaware law) suffice to ratify the plan, or do shareholders have to specifically ratify the fact that the plan was proposed by a self-interested board (and may constitute a breach fo duties)? Do shareholders have to be informed that the their vote in favor of the plan acts as ratification under Delaware law? What is the significance, if any, of the fact that New York Stock Exchange Rule require a shareholder vote on such plans? 3. What is the implication of Gantler on cases like Van Gorkom? Can shareholders have two votes, one on the merger and another ratification of potential breaches of fiduciary duties? Can the consummation of the merger be conditioned on getting the requisite shareholder approval in both votes? If it is not so conditioned, what incentive do shareholders have to vote in favor of ratification? If it is so conditioned, could the fact that shareholders need to vote for ratification if they want the merger to happen be construed as coercing shareholders to vote for ratification? 4. Question for later: What is the implication of Gantler on cases like Kahn v. Lynch (which we will do later)? Is a majority of minority voting requirement in mergers with a controlling shareholder the functional equivalent of ratification even though a favorable vote merely shifts the burden of proof? If no, does Gantler have any significance? If yes, the requirement of a separate vote imposed by Gantler seems to be met. But does the notion that the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve impose any additional obligations?

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Note on London [The rest of the opinion appears later in the supplement] 1. The Duty of Care Claims in Count I The SLC16 first addressed Count I, ultimately concluding that it should be dismissed. As the duty of care claims in Count I, the SLC found that the 8 Del. C. 102(b)(7) provision in iGov's corporate charter exculpates directors from personal liability for monetary damages so long as the director did not engage in intentional misconduct or knowing violations of the law. 81 The SLC concluded that a duty of care claim should not be pursued because defendants breach of care conduct, if it occurred, would be covered by the 102(b)(7) provision. I take this opportunity to note the first of many concerns I have with the conclusions in the SLC Report. In finding that the action should not be pursued on the basis of duty of care claims, the SLC noted that 102(b)(7) provisions such as iGov's are routinely upheld by Delaware courts and that such a provision protects defendants from personal liability, in the form of money damages, for gross negligence. On that basis alone, the SLC concluded that duty of care claims against defendants should not be pursued. I find this to be an unreasonable conclusion because the SLC failed to consider that the requested relief in plaintiffs' complaint is not limited to money damages; it specifically requests that the 2007 Plan be rescinded. Under Delaware law, exculpatory provisions do not bar duty of care claims "in remedial contexts . . ., such as in injunction or rescission cases." 82 Thus, if I became convinced at the summary judgment stage or after a trial on the merits that defendants breached their duty of care the exculpatory provision in the iGov charter would not preclude me from ordering rescission of the 2007 Plan, even though it might preclude me from entering a judgment for monetary damages against defendants. It was unreasonable, therefore, for the SLC to conclude that the duty of care claims in Count I should not go forward solely on the basis of iGov's 102(b)(7) provision. The SLC simply fails to understand that Delaware law permits a suit seeking rescission to go forward despite a 102(b)(7) provision protecting directors against monetary judgments.

[Prof note: SLC is special litigation committee. This is a Committee of the board appointed to decide whether it is in the firms interests to pursue a derivative action.
16

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Dodd Frank In response to the financial meltdown, Congress passed the Dodd-Frank Act in July 2010 that added new rules in multiple areas of financial regulation revealed by the failures of Lehman Brothers and AIG and the crisis that engulfed the economy in 2008 and thereafter. For example, the legislation provides new oversight and enhanced capital requirements for certain financial institutions that are too big to fail and the governments resolution authority when such firms fail has been broadened. Derivatives, a key flashpoint during the crisis, are now subject to government regulation, including swaps, the contractual arrangements that led to AIGs demise. Regulations are being drawn (although they remain behind the schedule specified by the statute and are being subjected to renewed political criticism particularly since the 2010 elections) to require a large number of derivatives to be traded on exchanges and cleared through clearing houses in an effort to reduce the amount of risk in those instruments. The Volcker rule prevents banks (which now includes the nations largest investment banks given the failures and restructuring that occurred during the crisis) from engaging in proprietary trading or investing in hedge funds. Hedge fund themselves are subject to registration. A variety of corporate law changes were included in this mammoth bill, pushing federal law more into internal corporate governance that is the subject of this book. Those changes include the following: Adding a second board committee, the compensation committee, which must be composed of independent directors. See Section 10C added to the 1934 Act. This is in addition to the requirement for independent directors on the audit requirement, which has been a federal law requirement since the Sarbanes-Oxley Act in 2002 and the requirements of the stock exchanges that require boards must have an overall majority of independent directors and that the nominating/governance committee, as well as the audit and compensation committee, must be made up of independent directors. See the NYSE listing standards in the Statutory Supplement. Enhanced compensation disclosure is required by the new law and there is regulation and disclosure of the use of compensation consultants. See Section 10C added to the 1934 Act. Public companies must have policies to claw back incentive-based compensation received by executive officers when there has been an accounting restatement. See Section 10D added to the 1934 Act. New Section 14A of the 1934 Act mandates a shareholder vote on executive compensation at least once every three years and to permit shareholders to determine how often review should occur during the three year period. As companies have responded to this requirement during 2011, most have adopted a shareholder vote every year and only 40 of 2582 companies tracked by an executive pay consultant lost their votes as to executive compensation. See Joann S. Lublin, Pay Starts to Bend to Advisory Votes, WALL STREET JOURNAL, July 29, 2011 at C3 c.5. By statute, these votes are advisory only, but companies typically adjust their pay practices after defeat or in response to pressure from institutional shareholders and proxy advising firms such as Institutional Shareholder Services. Id (reporting targeting of compensation committee members facing reelection). New Section 14B of the 1934 Act requires public companies to disclose in their proxy if they have spilt the jobs of chairperson of the board and chief executive officer, an example

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of the use of disclosure provisions to influence the substance of governance through a comply or explain approach. Dodd-Frank amended Section 14 of the 1934 Act to authorize SEC rules to require public companies to include nominees submitted by shareholders. SEC Rule 14a-11 was promulgated in August, 2010, then quickly challenged in court, stayed by the SEC pending judicial resolution, and was struck down by the DC circuit in a decision in July 2011 excerpted below. New Rules on Shareholder Say on Pay The Dodd-Frank Act extended the previous steps on say on pay to include regular precatory (i.e. advisory) shareholder votes in public corporations. New Section 14A of the 1934 Act mandates a shareholder vote on executive compensation at least once every three years and to permit shareholders to determine how often review should occur during the three year period. As companies have responded to this requirement during 2011, most have adopted a shareholder vote every year and only 40 of 2582 companies tracked by an executive pay consultant lost their votes. See Joann S. Lublin, Pay Starts to Bend to Advisory Votes, WALL STREET JOURNAL, July 29, 2011 at C3 c.5. By statute, these votes are advisory, but companies typically adjust their pay practices after defeat or in response to pressure from institutional shareholders and proxy advising firms such as Institutional Shareholder Services. Id (reporting targeting of compensation committee members facing reelection).

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QUESTIONS ON FRANCIS (1) What is plaintiff's claim? (2) Is this a Business Judgment Rule case? Why or why not? Does it really matter? (3) What is the test of whether a director breached her duty of care? Why exactly is the director here held liable for breach? (4) What is the court's holding? What minimum duties does the court put on directors? (5) What three arguments does Mrs. P have for why she isn't liable? Think about what they could be remembering that this is just a standard tort case? What are the elements of a tort case? (6) Why can't Mrs. P use Dela 141(e), arguing that she relied on her son's assurances. (7) What is a reinsurance brokerage firm? Why does the nature of the firm's business matter in this case? (8) If Mrs. P had discovered the wrongdoing, what would have happened? (9) What would you advise a director in Mrs P's position to do (someone without a lot of financial knowledge). (10) Why might the court have been especially harsh here? Who is ultimately going to bear the cost of the damage assessment?

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In re CAREMARK INTERNATIONAL INC. DERIVATIVE LITIGATION. Decided: Sept. 25, 1996. Parties to derivative suit seeking to impose personal liability on members of board of directors proposed settlement for court approval. The Court of Chancery, Allen, Chancellor, held that: (1) directors appeared to have followed procedures to inform themselves regarding contracts with health care providers before authorizing corporation to pursue contractual opportunities, so as to be protected under business judgment rule from claims of personal liability when impermissible contracts were entered into; (2) board appeared to have met responsibilities to monitor operation of corporation, even though some illegal contracts were entered into; and (3) settlement was fair, despite consideration for release of claims that was very modest, in view of weaknesses of complainants' case. Settlement approved. ALLEN, Chancellor. Pending is a motion pursuant to Chancery Rule 23.1 to approve as fair and reasonable a proposed settlement of a consolidated derivative action on behalf of Caremark International, Inc. (Caremark). The suit involves claims that the members of Caremark's board of directors (the Board) breached their fiduciary duty of care to Caremark in connection with alleged violations by Caremark employees of federal and state laws and regulations applicable to health care providers. As a result of the alleged violations, Caremark was subject to an extensive four year investigation by the United States Department of Health and Human Services and the Department of Justice. In 1994 Caremark was charged in an indictment with multiple felonies. It thereafter entered into a number of agreements with the Department of Justice and others. Those agreements included a plea agreement in which Caremark pleaded guilty to a single felony of mail fraud and agreed to pay civil and criminal fines. Subsequently, Caremark agreed to make reimbursements to various private and public parties. In all, the payments that Caremark has been required to make total approximately $250 million. This suit was filed in 1994, purporting to seek on behalf of the company recovery of these losses from the individual defendants who constitute the board of directors of Caremark.17The parties now propose that it be settled and, after notice to Caremark shareholders, a hearing on the fairness of the proposal was held on August 16, 1996. A motion of this type requires the court to assess the strengths and weaknesses of the claims asserted in light of the discovery record and to evaluate the fairness and adequacy of the consideration offered to the corporation in exchange for the release of all claims made or arising from the facts alleged. The ultimate issue then is whether the proposed settlement appears to be fair to the corporation and its absent shareholders. In this effort the court does not determine contested facts, but evaluates the claims and defenses on the discovery record to achieve a sense of the relative strengths of the parties' positions. Polk v. Good, Del.Supr., 507 A.2d 531, 536 (1986). In doing this, in most instances, the court is constrained by the absence of a truly adversarial process, since inevitably both sides support the settlement and legally assisted
Thirteen of the Directors have been members of the Board since November 30, 1992. Nancy Brinker joined the Board in October 1993.
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objectors are rare. Thus, the facts stated hereafter represent the court's effort to understand the context of the motion from the discovery record, but do not deserve the respect that judicial findings after trial are customarily accorded. Legally, evaluation of the central claim made entails consideration of the legal standard governing a board of directors' obligation to supervise or monitor corporate performance. For the reasons set forth below I conclude, in light of the discovery record, that there is a very low probability that it would be determined that the directors of Caremark breached any duty to appropriately monitor and supervise the enterprise. Indeed the record tends to show an active consideration by Caremark management and its Board of the Caremark structures and programs that ultimately led to the company's indictment and to the large financial losses incurred in the settlement of those claims. It does not tend to show knowing or intentional violation of law. Neither the fact that the Board, although advised by lawyers and accountants, did not accurately predict the severe consequences to the company that would ultimately follow from the deployment by the company of the strategies and practices that ultimately led to this liability, nor the scale of the liability, gives rise to an inference of breach of any duty imposed by corporation law upon the directors of Caremark. I. BACKGROUND *** (see Corporate Stories chapter) E. Settlement Negotiations *** Caremark began settlement negotiations with federal and state government entities in May 1995. In return for a guilty plea to a single count of mail fraud by the corporation, the payment of a criminal fine, the payment of substantial civil damages, and cooperation with further federal investigations on matters relating to the OIG investigation, the government entities agreed to negotiate a settlement that would permit Caremark to continue participating in Medicare and Medicaid programs. On June 15, 1995, the Board approved a settlement (Government Settlement Agreement) with the DOJ, OIG, U.S. Veterans Administration, U.S. Federal Employee Health Benefits Program, federal Civilian Health and Medical Program of the Uniformed Services, and related state agencies in all fifty states and the District of Columbia.FN10 No senior officers or directors were charged with wrongdoing in the Government Settlement Agreement or in any of the prior indictments. In fact, as part of the sentencing in the Ohio action on June 19, 1995, the United States stipulated that no senior executive of Caremark participated in, condoned, or was willfully ignorant of wrongdoing in connection with the home infusion business practices.FN11 FN10. The agreement, covering allegations since 1986, required a Caremark subsidiary to enter a guilty plea to two counts of mail fraud, and required Caremark to pay $29 million in criminal fines, $129.9 million relating to civil claims concerning payment practices, $3.5 million for alleged violations of the Controlled Substances Act, and $2 million, in the form of a donation, to a grant program set up by the Ryan White Comprehensive AIDS Resources Emergency Act. Caremark also agreed to enter into a compliance agreement with the HHS.

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**** Settlement negotiations between the parties in this action commenced in May 1995 as well, based upon a letter proposal of the plaintiffs, dated May 16, 1995.FN12 These negotiations resulted in a memorandum of understanding (MOU), dated June 7, 1995, and the execution of the Stipulation and Agreement of Compromise and Settlement on June 28, 1995, which is the subject of this action.FN13 The MOU, approved by the Board on June *966 15, 1995, required the Board to adopt several resolutions, discussed below, and to create a new compliance committee. The Compliance and Ethics Committee has been reporting to the Board in accord with its newly specified duties. **** II. LEGAL PRINCIPLES A. Principles Governing Settlements of Derivative Claims As noted at the outset of this opinion, this Court is now required to exercise an informed judgment whether the proposed settlement is fair and reasonable in the light of all relevant factors. Polk v. Good, Del.Supr., 507 A.2d 531 (1986). On an application of this kind, this Court attempts to protect the best interests of the corporation and its absent shareholders all of whom will *967 be barred from future litigation on these claims if the settlement is approved. The parties proposing the settlement bear the burden of persuading the court that it is in fact fair and reasonable. Fins v. Pearlman, Del.Supr., 424 A.2d 305 (1980). B. Directors' Duties To Monitor Corporate Operations The complaint charges the director defendants with breach of their duty of attention or care in connection with the on-going operation of the corporation's business. The claim is that the directors allowed a situation to develop and continue which exposed the corporation to enormous legal liability and that in so doing they violated a duty to be active monitors of corporate performance. The complaint thus does not charge either director self-dealing or the more difficult loyalty-type problems arising from cases of suspect director motivation, such as entrenchment or sale of control contexts.FN14 The theory here advanced is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment. The good policy reasons why it is so difficult to charge directors with responsibility for corporate losses for an alleged breach of care, where there is no conflict of interest or no facts suggesting suspect motivation involved, were recently described in Gagliardi v. TriFoods Int'l, Inc., Del.Ch., 683 A.2d 1049, 1051 (1996)(1996 Del.Ch. LEXIS 87 at p. 20). 1. Potential liability for directoral decisions: Director liability for a breach of the duty to exercise appropriate attention may, in theory, arise in two distinct contexts. First, such liability may be said to follow from a board decision that results in a loss because that decision was ill advised or negligent. Second, liability to the corporation for a loss may be said to arise from an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss. See generally Veasey & Seitz,

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The Business Judgment Rule in the Revised Model Act...63 TEXAS L.REV. 1483 (1985). The first class of cases will typically be subject to review under the director-protective business judgment rule, assuming the decision made was the product of a process that was either deliberately considered in good faith or was otherwise rational. See Aronson v. Lewis, Del.Supr., 473 A.2d 805 (1984); Gagliardi v. TriFoods Int'l, Inc., Del.Ch., 683 A.2d 1049 (1996). What should be understood, but may not widely be understood by courts or commentators who are not often required to face such questions, is that compliance with a director's duty of care can never appropriately be judicially determined by reference to the content of the board decision that leads to a corporate loss, apart from consideration of the good faith or rationality of the process employed. That is, whether a judge or jury considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through stupid to egregious or irrational, provides no ground for director liability, so long as the court determines that the process employed was either rational or employed in a good faith effort to advance corporate interests. To employ a different rule-one that permitted an objective evaluation of the decision-would expose directors to substantive second guessing by ill-equipped judges or juries, which would, in the long-run, be injurious to investor interests.18 Thus, the business*968 judgment rule is process oriented and informed by a deep respect for all good faith board decisions. [Emphasis added by Prof] Indeed, one wonders on what moral basis might shareholders attack a good faith business decision of a director as unreasonable or irrational. Where a director in fact exercises a good faith effort to be informed and to exercise appropriate judgment, he or she should be deemed to satisfy fully the duty of attention. If the shareholders thought themselves entitled to some other quality of judgment than such a director produces in the good faith exercise of the powers of office, then the shareholders should have elected other directors. Judge Learned Hand made the point rather better than can I. In speaking of the passive director defendant Mr. Andrews in Barnes v. Andrews, Judge Hand said: True, he was not very suited by experience for the job he had undertaken, but I cannot hold him on that account. After all it is the same corporation that chose him that now seeks to charge him.... Directors are not specialists like lawyers or doctors.... They are the general advisors of the business and if they faithfully give such ability as they have to their charge, it would not be lawful to hold them liable. Must a director guarantee that his judgment is good? Can a shareholder call him to account for deficiencies that their votes assured him did not disqualify him for his office? While he may not have been
18 The vocabulary of negligence while often employed, e.g., Aronson v. Lewis, Del.Supr., 473 A.2d 805 (1984) is not well-suited to judicial review of board attentiveness, see, e.g., Joy v. North, 692 F.2d 880, 885-6 (2d Cir.1982), especially if one attempts to look to the substance of the decision as any evidence of possible negligence. Where review of board functioning is involved, courts leave behind as a relevant point of reference the decisions of the hypothetical reasonable person, who typically supplies the test for negligence liability. It is doubtful that we want business men and women to be encouraged to make decisions as hypothetical persons of ordinary judgment and prudence might. The corporate form gets its utility in large part from its ability to allow diversified investors to accept greater investment risk. If those in charge of the corporation are to be adjudged personally liable for losses on the basis of a substantive judgment based upon what an persons of ordinary or average judgment and average risk assessment talent regard as prudent sensible or even rational, such persons will have a strong incentive at the margin to authorize less risky investment projects.

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the Cromwell for that Civil War, Andrews did not engage to play any such role. In this formulation Learned Hand correctly identifies, in my opinion, the core element of any corporate law duty of care inquiry: whether there was good faith effort to be informed and exercise judgment. 2. Liability for failure to monitor: The second class of cases in which director liability for inattention is theoretically possible entail circumstances in which a loss eventuates not from a decision but, from unconsidered inaction. Most of the decisions that a corporation, acting through its human agents, makes are, of course, not the subject of director attention. Legally, the board itself will be required only to authorize the most significant corporate acts or transactions: mergers, changes in capital structure, fundamental changes in business, appointment and compensation of the CEO, etc. As the facts of this case graphically demonstrate, ordinary business decisions that are made by officers and employees deeper in the interior of the organization can, however, vitally affect the welfare of the corporation and its ability to achieve its various strategic and financial goals. If this case did not prove the point itself, recent business history would. Recall for example the displacement of senior management and much of the board of Salomon, Inc.; the replacement of senior management of Kidder, Peabody following the discovery of large trading losses resulting from phantom trades by a highly compensated trader; or the extensive financial loss and reputational injury suffered by Prudential Insurance as a result its junior officers misrepresentations in connection with the distribution of limited partnership interests. Financial and organizational disasters such as these raise the question, what is *969 the board's responsibility with respect to the organization and monitoring of the enterprise to assure that the corporation functions within the law to achieve its purposes? Modernly this question has been given special importance by an increasing tendency, especially under federal law, to employ the criminal law to assure corporate compliance with external legal requirements, including environmental, financial, employee and product safety as well as assorted other health and safety regulations. In 1991, pursuant to the Sentencing Reform Act of 1984, the United States Sentencing Commission adopted Organizational Sentencing Guidelines which impact importantly on the prospective effect these criminal sanctions might have on business corporations. The Guidelines set forth a uniform sentencing structure for organizations to be sentenced for violation of federal criminal statutes and provide for penalties that equal or often massively exceed those previously imposed on corporations. The Guidelines offer powerful incentives for corporations today to have in place compliance programs to detect violations of law, promptly to report violations to appropriate public officials when discovered, and to take prompt, voluntary remedial efforts. In 1963, the Delaware Supreme Court in Graham v. Allis-Chalmers Mfg. Co., addressed the question of potential liability of board members for losses experienced by the corporation as a result of the corporation having violated the anti-trust laws of the United States. *** The Delaware Supreme Court concluded that, under the facts as they appeared, there was no basis to find that the directors had breached a duty to be informed of the ongoing operations of the firm. In notably colorful terms, the court stated that absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing

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which they have no reason to suspect exists. The Court found that there were no grounds for suspicion in that case and, thus, concluded that the directors were blamelessly unaware of the conduct leading to the corporate liability. How does one generalize this holding today? Can it be said today that, absent some ground giving rise to suspicion of violation of law, that corporate directors have no duty to assure that a corporate information gathering and reporting systems exists which represents a good faith attempt to provide senior management and the Board with information respecting material acts, events or conditions within the corporation, including compliance with applicable statutes and regulations? I certainly do not believe so. *** *** In stating the basis for this view, I start with the recognition that in recent years the Delaware Supreme Court has made it clear-especially in its jurisprudence concerning takeovers, from Smith v. Van Gorkom through Paramount Communications v. QVC-the seriousness with which the corporation law views the role of the corporate board. Secondly, I note the elementary fact that relevant and timely information is an essential predicate for satisfaction of the board's supervisory and monitoring role under Section 141 of the Delaware General Corporation Law. Thirdly, I note the potential impact of the federal organizational sentencing guidelines on any business organization. Any rational person attempting in good faith to meet an organizational governance responsibility would be bound to take into account this development and the enhanced penalties and the opportunities for reduced sanctions that it offers. In light of these developments, it would, in my opinion, be a mistake to conclude that our Supreme Court's statement in Graham concerning espionage means that corporate boards may satisfy their obligation to be reasonably informed concerning the corporation, without assuring themselves that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation's compliance with law and its business performance. Obviously the level of detail that is appropriate for such an information system is a question of business judgment (emphasis added). And obviously too, no rationally designed information and reporting system will remove the possibility that the corporation will violate laws or regulations, or that senior officers or directors may nevertheless sometimes be misled or otherwise fail reasonably to detect acts material to the corporation's compliance with the law. But it is important that the board exercise a good faith judgment that the corporation's information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibility. Thus, I am of the view that a director's obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards 19. I
Any action seeking recover for losses would logically entail a judicial determination of proximate cause, since, for reasons that I take to be obvious, it could never be assumed that an adequate information system would be a system
19

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now turn to an analysis of the claims asserted with this concept of the directors duty of care, as a duty satisfied in part by assurance of adequate information flows to the board, in mind. III. ANALYSIS OF THIRD AMENDED COMPLAINT AND SETTLEMENT A. The Claims On balance, after reviewing an extensive record in this case, including numerous documents and three depositions, I conclude that this settlement is fair and reasonable. In light of the fact that the Caremark Board already has a functioning committee charged with overseeing corporate compliance, the changes in corporate practice that are presented as consideration for the settlement do not impress one as very significant. Nonetheless, that consideration* appears fully adequate to support dismissal of the derivative claims of director fault asserted, because those claims find no substantial evidentiary support in the record and quite likely were susceptible to a motion to dismiss in all events. In order to show that the Caremark directors breached their duty of care by failing adequately to control Caremark's employees, plaintiffs would have to show either (1) that the directors knew or (2) should have known that violations of law were occurring and, in either event, (3) that the directors took no steps in a good faith effort to prevent or remedy that situation, and (4) that such failure proximately resulted in the losses complained of, although under Cede & Co. v. Technicolor, Inc., Del.Supr., 636 A.2d 956 (1994) this last element may be thought to constitute an affirmative defense. [emphasis added] 1. Knowing violation for statute: Concerning the possibility that the Caremark directors knew of violations of law, none of the documents submitted for review, nor any of the deposition transcripts appear to provide evidence of it. Certainly the Board understood that the company had entered into a variety of contracts with physicians, researchers, and health care providers and it was understood that some of these contracts were with persons who had prescribed treatments that Caremark participated in providing. The board was informed that the company's reimbursement for patient care was frequently from government funded sources and that such services were subject to the ARPL. But the Board appears to have been informed by experts that the company's practices while contestable, were lawful. There is no evidence that reliance on such reports was not reasonable. Thus, this case presents no occasion to apply a principle to the effect that knowingly causing the corporation to violate a criminal statute constitutes a breach of a director's fiduciary duty. **** It is not clear that the Board knew the detail found, for example, in the indictments arising from the Company's payments. But, of course, the duty to act in good faith to be informed cannot be thought to require directors to possess detailed information about all aspects of the operation of the enterprise. Such a requirement would simple be inconsistent with the scale and scope of efficient organization size in this technological age. 2. Failure to monitor: Since it does appears that the Board was to some extent unaware
that would prevent all losses. I need not touch upon the burden allocation with respect to a proximate cause issue in such a suit. See Cede & Co. v. Technicolor, Inc., Del.Supr., 636 A.2d 956 (1994); Cinerama, Inc. v. Technicolor, Inc., Del.Ch., 663 A.2d 1134 (1994), aff'd,Del.Supr., 663 A.2d 1156 (1995). Moreover, questions of waiver of liability under certificate provisions authorized by 8 Del.C. 102(b)(7) may also be faced.

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of the activities that led to liability, I turn to a consideration of the other potential avenue to director liability that the pleadings take: director inattention or negligence. Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation, as in Graham or in this case, in my opinion only a sustained or systematic failure of the board to exercise oversight-such as an utter failure to attempt to assure a reasonable information and reporting system exists-will establish the lack of good faith that is a necessary condition to liability. Such a test of liability-lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight-is quite high. But, a demanding test of liability in the oversight context is probably beneficial to corporate shareholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors. Here the record supplies essentially no evidence that the director defendants were guilty of a sustained failure to exercise their oversight function. [emphasis added] To the contrary, insofar as I am able to tell on this record, the corporation's information systems appear to have represented a good faith attempt to be informed of relevant facts. If the directors did not know the specifics of the activities *972 that lead to the indictments, they cannot be faulted. The liability that eventuated in this instance was huge. But the fact that it resulted from a violation of criminal law alone does not create a breach of fiduciary duty by directors. The record at this stage does not support the conclusion that the defendants either lacked good faith in the exercise of their monitoring responsibilities or conscientiously permitted a known violation of law by the corporation to occur. The claims asserted against them must be viewed at this stage as extremely weak. B. The Consideration For Release of Claim The proposed settlement provides very modest benefits. Under the settlement agreement, plaintiffs have been given express assurances that Caremark will have a more centralized, active supervisory system in the future. Specifically, the settlement mandates duties to be performed by the newly named Compliance and Ethics Committee on an ongoing basis and increases the responsibility for monitoring compliance with the law at the lower levels of management. In adopting the resolutions required under the settlement, Caremark has further clarified its policies concerning the prohibition of providing remuneration for referrals. These appear to be positive consequences of the settlement of the claims brought by the plaintiffs, even if they are not highly significant. Nonetheless, given the weakness of the plaintiffs' claims the proposed settlement appears to be an adequate, reasonable, and beneficial outcome for all of the parties. Thus, the proposed settlement will be approved. ***** I am today entering an order consistent with the foregoing.

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Questions on Stone 1. To the extent that one is tempted to impose liability on the board for purposes of enforcing the criminal laws, what alternative enforcement strategies are available? What about increased penalties against the company? 2. Should the standard of care vary with the type of director? Should the individual ability of a director matter? Should directors serving on a board committee charged with supervising compliance with laws be held to a higher standard? 3. What is the board met to discuss compliance and were presented with a report by their compliance officer which said that the only plausible compliance measures were too expensive given the small size of the probability of wrongdoing was low and probability of detection. They vote not to implement compliance measures. Later a crime takes place resulting in millions of dollars in penalties. What result if a shareholder sues claiming that the board breached its duty of care?

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The New Dodd Frank Whistleblower Rules On May 25 the SEC adopted new rules governing whistleblowing. First, it is important to remember what has not changed: the new rules still permit and indeed encourage both privately held and publicly traded companies to continue doing what most have been doing for years: (1) actively encouraging all employees to report potential compliance violations to the company, either by directly reporting any concerns to supervisors, legal, compliance or audit personnel, or by using confidential hotline, website or ombudsmen mechanisms; (2) assuring all employees who step forward that they will not be terminated or otherwise discriminated or retaliated against for raising good faith compliance concerns; (3) examining, in a responsible and appropriate way, all reported potential compliance issues; and (4) taking reasonable corrective measures, including changing business practices and systems, imposing discipline, and when appropriate, reporting the issue to regulators. While it would have been better, as we and others previously stated (see our prior memo here), for the SEC to have fully respected those programs by requiring whistleblowers to first make an internal report, this does not mean that corporate compliance regimes have become obsolete. In fact, they have become even more important. Second, it also is important to recognize that what is new is relatively limited: Dodd Franks heightened financial incentives for whistleblowers (who can now hope to receive 10% to 30% of any monetary sanction over $1 million that results from their report of original information to the SEC) can reasonably be expected to increase the number of whistleblower reports and to impose greater burdens on companies facing inquiries resulting from such reports. But, as SEC Enforcement Director Robert Khuzami reported at a SIFMA-sponsored luncheon in New York last week, the staff has not seen a big spike in whistleblower reports. He did note that, at least in some cases, the overall quality and extent of documentation supporting the tips the SEC is now receiving has improved, which he attributed to whistleblower lawyers doing more careful vetting of the reports and shaping what is said so that it will more readily appear to be of interest to the SEC. Third, for companies considering how best to respond to these new rules, we do not see a need for most companies to substantially revamp their policies, if they already have in place the elements described above. We do, however, strongly recommend taking affirmative steps to reinforce and repeat the key message that all employees are encouraged to report any compliance concerns directly to the company. If you plan to repeat those messages, keep in mind the following: (1) Tone at the Top: the voice that carries farthest within any company comes from the top so, consider having your CEO speak periodically about the importance of maintaining an effective compliance culture and the need for employees to recognize that they are the companys first line of defense and should therefore report promptly any compliance concerns they spot; this message can be conveyed by the CEO at periodic town halls with employees, through letters or intranet messages;

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(2) Effective Training: the fact that periodic training has been conducted should be well documented, including by securing annual certifications from employees that they have received such training and have reported any compliance concerns of which they are aware; (3) Compliance as an element of job performance: including a compliance evaluation component, as well as elements that encourage compliance reporting can be useful tools in annual job performance evaluations, and any new information that is reported should be documented and examined; (4) Hotlines: periodic refreshers should be sent out reminding employees of the easy availability of hotlines and other reporting mechanisms, as well as reinforcing the message that the companys Code of Conduct calls for all employees to use these tools; (5) Prompt responses to reports: when compliance and/or HR reports are made, it is critical that the company investigate promptly and thoroughly, and that it communicate regularly and effectively with the employee making the report, so that potential issues are seen to be receiving appropriate attention, concerns do not fester, and small problems do not grow, through inattention, into major issues; (6) Exit procedures: whenever an employee is exiting from the company, the exit interview should include a compliance component that solicits a report by the exiting employee of any compliance issues, which can then be documented and followed up; (7) Supervisory training: supervisors should receive special training to teach them how to encourage self-reporting by employees of possible compliance violations and to avoid engaging in any form of retaliation or discrimination against employees who do make such reports; and (8) Incentives to report to the company: at least in some cases, it may be advisable for example, in response to questions that may be raised by employees -- to remind them that the new SEC rules actually contain several significant incentives for employees to first report their concerns to the company: (i) if they report first to the company, and then either the company or employee reports to the SEC within 120 days of that first internal report, the employees place in line will date from his/her first internal report to the company; (ii) if a monetary sanction does result, the final SEC rules say that employee will likely get a larger reward (within the 10% to 30% range) if they reported first to the company (and less if they didnt); and (iii) if the company ultimately reports to the SEC a broader set of concerns than the employee initially had, the employee will get full credit for the entire set of concerns reported by the company. Reminding employees of these rules will not only increase the chances that employees will decide to first report their concerns to the company, it will also provide a welldocumented record of the companys good faith effort to establish a culture of compliance which can have an enormously positive impact on the thinking of SEC enforcement lawyers, prosecutors and other regulators if an investigation does arise. One final element also has not changed: if and when a company decides to self-report to a regulator, or if the SEC gives a company notice of a whistleblower report and asks the company to respond, as it has said it will likely do in many cases, a companys ability to maintain credible and effective lines of communication with the SEC staff will remain critically important.

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LOUISIANA MUNICIPAL POLICE EMPLOYEES RETIREMENT SYSTEM (LMPERS) v.Pyott 46 A.3d 313 Court of Chancery of Delaware Decided June 11, 2012. Laster, Vice Chancellor [Background: Allergan, Inc. (Allergan) manufactures the muscle relaxant Botox. In a settlement with the United States Department of Justice on September 1, 2010, Allergan pleaded guilty to claims of misbranding and off-label marketing of Botox from 2000-2005. Allergan agreed to pay $600 million in criminal and civil fines, exceeding its net income in each of the previous two years and constituting 96% of its net income in 2010. Within days of the settlement, Louisiana Municipal Police Employees Retirement System (LAMPERS) commenced an action in Delaware, relying solely on public information and Allergans press release announcing the settlement, and later amended the complaint with additional public information. Within three weeks, three similar derivative suits were filed in the United States District Court for the Central District of California and were eventually consolidated (the California Litigation). Allergan moved to dismiss all complaints. In November of 2010, the U.F.C.W. Local 1776 & Participating Employment Pension Fund (UFCW) made a books and records demand on Allergan under 8 Del. C. 220 and moved to intervene in LAMPERS v. Pyott. ] The courts discussion of the Caremark case is useful for understanding Caremark A breach of fiduciary duty claim that seeks to hold directors accountable for the consequences of a corporate trauma is known colloquially as a Caremark claim, in a tip of the judicial hat to Chancellor Allens landmark decision. See In re Caremark Intl Inc. Deriv. Litig., 698 A.2d 959 (Del.Ch.1996). Because it is safe to say that non-sociopathic directors never consciously choose for the entity they oversee to suffer a disaster, a Caremark claim contends that the directors set in motion or allowed a situation to develop and continue which exposed the corporation to enormous legal liability and that in doing so they violated a duty to be active monitors of corporate performance. Id. at 967. The list of corporate traumas for which stockholders theoretically could seek to hold directors accountable is long and ever expanding: regulatory sanctions, criminal or civil fines, environmental disasters, accounting restatements, misconduct by officers or employees, massive business losses, and innumerable other potential calamities. *** [The court says that a shareholder can hold a board liable for a corporate calamity involving a violation of law under four circumstances: (1) allege with particularity actual board involvement in a decision that violated positive law. *** (2) to plead that the board consciously [failed to act after learning about evidence of illegalitythe proverbial red flag. [emphasis added]*** (3) plead that a board of directors is dominated or controlled by key members of management, who the rest of the board unknowingly allowed to engage in self-dealing transactions. *** (4) the boards obligation to adopt internal information and reporting systems that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporations compliance with law and its business performance. If a corporation suffers losses proximately caused by illegal conduct, and if the directors failed to attempt in good faith to assure that a corporate information and reporting

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system, which the board concludes is adequate, exists, then there is a sufficient connection between the occurrence of the illegal conduct and board level action or conscious inaction to support liability. Caremark, 698 A.2d at 970.] The burden on a plaintiff when seeking to establish liability under this final route is quite high. [Court reiterates the standard from Caremark and notes that it parallels the standard for imposing damages when a corporation has an exculpatory provision adopted pursuant to 8 Del. C. 102(b)(7). **** A failure to act in good faith may be shown, for instance, [1] where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, [2] where the fiduciary acts with the intent to violate applicable positive law, or [3] where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proven or alleged, but these three are the most salient. *** A Caremark claim based on the failure to establish a monitoring system seeks to invoke the third of these examples. *** [Courts discussion of the merits] In this case, the plaintiffs do not seek to impose liability on the Allergan directors for making a wrong business decision or taking imprudent business risks. *** Corporate misconduct involving fraud or illegality presents a different situation. *** Delaware law does not charter law breakers.*** Delaware law allows corporations to pursue diverse means to make a profit, subject to a critical statutory floor, which is the requirement that Delaware corporations only pursue lawful business by lawful acts. Id. (citing 8 Del. C. 101 & 102). Under Delaware law, a fiduciary may not choose to manage an entity in an illegal fashion, even if the fiduciary believes that the illegal activity will result in profits for the entity. ***. In short, by consciously causing the corporation to violate the law, a director would be disloyal to the corporation and could be forced to answer for the harm he has caused. Although directors have wide authority to take lawful action on behalf of the corporation, they have no authority knowingly to cause the corporation to become a rogue, exposing the corporation to penalties from criminal and civil regulators. Delaware corporate law has long been clear on this rather obvious notion; namely, that it is utterly inconsistent with ones duty of fidelity to the corporation to consciously cause the corporation to act unlawfully. The knowing use of illegal means to pursue profit for the corporation is director misconduct. *** As a result, a fiduciary of a Delaware corporation cannot be loyal to a Delaware corporation by knowingly causing it to seek profits by violating the law. *** The plaintiffs in this case have alleged a direct connection between the Board and a business plan premised on illegal activity. The Complaint pleads that from 1997 onward, the Board discussed and approved a series of annual strategic plans that contemplated expanding Botox sales dramatically within geographic areas that encompassed the United States. The plans contemplated new markets for Botox that involved applications that were off-label uses in the United States. So significant was the scope of the expansion that it necessarily contemplated marketing and promoting off-label uses within the United States. The Board then closely

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monitored Allergans dramatic success in increasing its sales of Botox at rates far exceeding what the market for existing on-label uses could support or that could be generated by physicians serendipitously learning about and trying new off-label applications. The Board kept Allergans business plan in place even after the Schim incident and FDA inquiries illustrated the extent of Allergans regulatory exposure. From these allegations, one can reasonably infer that the Board knowingly approved and monitored a business plan that contemplated illegality. Critically, the Complaint does not merely allege that this misconduct took place. Unlike the parade of hastily filed Caremark complaints that Delaware courts have dismissed, and like those rare Caremark complaints that prior decisions have found adequate, the Complaint supports these allegations with references to internal Allergan books and records that UFCW obtained using Section 220. [emphasis added] [Court details the support that the board approved support off-label use and continued to do so after learning about FDA inquiries and that some of its sponsored speakers were using materials that dont comply with FDA regulations] *** Ten of the twelve defendant directors have served on the Board since 2005 and earlier. One can reasonably infer that these directors approved multiple iterations of Allergans strategic plan, monitored Botoxs explosive sales growth, learned of the Schim incident in October 2006, then approved the 2007 Strategic Plan, fully conscious of the role of off-label marketing in Allergans success. The inference is more tenuous for Dunsire and Hudson, who joined the Board in 2006 and 2008, respectively. Because the Complaint implicates more than half of the Board, I need not make any determination one way or the other as to those two directors. It is not unreasonable to infer that the Allergan Board, led by a hard-charging CEO who earned the nickname Mr. Botox, could have believed that Allergan knew better than the FDA which Botox applications were safe, particularly off-label uses already approved (or at least permitted) in other countries. It is not unreasonable to infer that the Board and CEO saw the distinction between off-label selling and off-label marketing as a source of legal risk to be managed, rather than a boundary to be avoided. Based on this premise, the CEO and his management team devised, and the Board approved, a business plan that relied on off-label-use-promoting activities, confident that the risk of regulatory detection was low, that most regulatory problems could be solved, and that dealing with regulatory risk was a cost of doing business. As profits increased and the regulatory risk seemed well managed, the extent of off-label use-promoting activities grew. The appearance of formal compliance cloaked the reality of non-compliance, and directors who understood the difference between legal off-label sales and illegal off-label marketing continued to approve and oversee business plans that depended on illegal activity. See Massey Energy, 2011 WL 2176479, at *19 (crediting inference that outside directors went through the motions rather than making good faith efforts to ensure that [the company] cleaned up its act). Obviously this is not the only inference that can be drawn. Alternatively, one could infer that the directors received advice from sophisticated counsel about the difference between legal off-label sales and illegal off-label marketing, understood where the boundary lay, and approved a business plan and management initiatives in the good faith belief that Allergan was remaining within the bounds of the law, although perhaps close to the edge. The directors then closely monitored Allergans performance with this understanding. Unfortunately for everyone, the

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directors good faith belief proved incorrect, and Allergan pled guilty to criminal misdemeanor misbranding for the period from 2000 through 2005, paid criminal fines of $375 million, and paid another $225 million in civil fines. If this scenario proves true, then the directors will not have acted in bad faith and will not be liable to Allergan for any of the harm it suffered. I cannot presently determine what actually happened at Allergan. I hold only that a reasonable inference can be drawn from the particularized allegations of the Complaint and the documents it incorporates by reference that the Board knowingly approved and subsequently oversaw a business plan that required illegal off-label marketing and support initiatives for Botox. At this stage of the case, I must credit this inference, even if I believe it more likely that the directors acted in good faith. The complaint need not plead particularized facts sufficient to sustain a judicial finding either of director interest or lack of director independence or other disabling factor. Grobow, 539 A.2d at 183. Nor must it demonstrate a reasonable probability of success. Rales, 634 A.2d at 93435. The complaint needs only to make a threshold showing, through the allegation of particularized facts, that their claims have some merit. Id. at 934. I believe the Complaint meets this standard. In reaching this conclusion, I part company with the California Federal Court and find unpersuasive the analysis in the California Judgment. The California Federal Court correctly described Delaware law in stating that that the California complaint only could survive a Rule 23.1 motion to dismiss if the particularized allegations presented the directors with a substantial threat of liability. *** In my view, a plaintiff does not have to point to actual confessions of illegality by defendant directors to survive a Rule 23.1 motion in a Caremark case. Particularly at the pleadings stage, a court can draw the inference of wrongful conduct when supported by particularized allegations of fact. Given that off-label marketing is illegal, it would be astounding if the 19972001 Strategic Plan or any other board presentation actually used that term. **** When, as here, the pled facts can support a reasonable inference that directors in fact approved a business plan that contemplated off-label marketing, the plaintiffs receive the benefit of the inference at the pleadings stage. ***As should be abundantly clear, this is a pleadings-stage decision. To prevail ultimately, the plaintiffs actually will have to prove their claims. At later stages of the case, the plaintiffs will not be entitled to pleadings-stage presumptions, and the defendants will have strong arguments against liability. See Massey Energy, 2011 WL 2176479, at *2021. For present purposes, however, the plaintiffs need only plead particularized allegations that support a reasonable inference that their claims have some merit. Rales, 634 A.2d at 934. Because the plaintiffs have met this standard, the Rule 23.1 motion is denied. III. CONCLUSION As Chancellor Allen famously observed, a Caremark theory is possibly the most *359 difficult theory in corporation law upon which a plaintiff might hope to win a judgment. 698 A.2d at 967. But difficult does not mean impossible, and win a judgment does not mean survive a motion to dismiss. **** Here, the particularized allegations support a reasonable inference that the Board knowingly approved a business plan that contemplated illegal off-label marketing in the United States. The particularized allegations of the Complaint, which are supported by internal documents obtained through Section 220, present a substantial threat of liability for all but two members of the Board.

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Court of Chancery of Delaware. In re CITIGROUP INC. SHAREHOLDER DERIVATIVE LITIGATION. Decided: Feb. 24, 2009. CHANDLER, Chancellor. This is a shareholder derivative action brought on behalf of Citigroup Inc. (Citigroup or the Company), seeking to recover for the Company its losses arising from exposure to the subprime lending market. Plaintiffs, shareholders of Citigroup, brought this action against current and former directors and officers of Citigroup, alleging, in essence, that the defendants breached their fiduciary duties by failing to properly monitor and manage the risks the Company faced from problems in the subprime lending market and for failing to properly disclose Citigroup's exposure to subprime assets. Plaintiffs allege that there were extensive red flags that should have given defendants notice of the problems that were brewing in the real estate and credit markets and that defendants ignored these warnings in the pursuit of short term profits and at the expense of the Company's long term viability. Pending before the Court is defendants' motion (1) to dismiss or stay the action in favor of an action pending in the Southern District of New York (the New York Action) or (2) to dismiss the complaint for failure to state a claim under Court of Chancery Rule 12(b)(6) and for failure to properly plead demand futility under Court of Chancery Rule 23.1. For the reasons set forth below, the motion to stay or dismiss in favor of the New York Action is denied. The motion to dismiss is denied as to the claim in Count III for waste for approval of the November 4, 2007 Prince letter agreement. All other claims are dismissed for failure to adequately plead demand futility pursuant to Rule 23.1. I. BACKGROUND A. The Parties Citigroup is a global financial services company whose businesses provide a broad range of financial services to consumers and businesses. Citigroup was incorporated in Delaware in 1988 and maintains its principal executive offices in New York, New York. Defendants in this action are current and former directors and officers of Citigroup. The complaint names thirteen members of the Citigroup board of directors on November 9, 2007, when the first of plaintiffs' now-consolidated derivative actions was filed. Plaintiffs allege that a majority of the director defendants were members of the Audit and Risk Management Committee (ARM Committee) in 2007 and were considered audit committee financial experts as defined by the Securities and Exchange Commission. Plaintiffs Montgomery County Employees' Retirement Fund, City of New Orleans Employees' Retirement System, Sheldon M. Pekin Irrevocable Descendants Trust Dated 10/01/01, and Carole Kops are all owners of shares of Citigroup stock. *** C. Plaintiffs' Claims Plaintiffs allege that defendants are liable to the Company for breach of fiduciary duty for (1) failing to adequately oversee and manage Citigroup's exposure to the problems in the subprime mortgage market, even in the face of alleged red flags .

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III. THE MOTION TO DISMISS UNDER RULE 23.1 *** Plaintiffs' argument is based on a theory of director liability famously articulated by former-Chancellor Allen in In re Caremark.FN37 *** 1. Plaintiffs' Caremark Allegations Plaintiffs' theory of how the director defendants will face personal liability is a bit of a twist on the traditional Caremark claim. In a typical Caremark case, plaintiffs argue that the defendants are liable for damages that arise from a failure to properly monitor or oversee employee misconduct or violations of law.*** In contrast, plaintiffs' Caremark claims are based on defendants' alleged failure to properly monitor Citigroup's business risk, specifically its exposure to the subprime mortgage market. In their answering brief, plaintiffs allege that the director defendants are personally liable under Caremark for failing to make a good faith attempt to follow the procedures put in place or fail[ing] to assure that adequate and proper corporate information and reporting systems existed that would enable them to be fully informed regarding Citigroup's risk to the subprime mortgage market. FN49 Plaintiffs point to so-called red flags that should have put defendants on notice of the problems in the subprime mortgage market and further allege that the board should have been especially conscious of these red flags because a majority of the directors (1) served on the Citigroup board during its previous Enron related conduct and (2) were members of the ARM Committee and considered financial experts. Although these claims are framed by plaintiffs as Caremark claims, plaintiffs' theory essentially amounts to a claim that the director defendants should be personally liable to the Company because they failed to fully recognize the risk posed by subprime securities. When one looks past the lofty allegations of duties of oversight and red flags used to dress up these claims, what is left appears to be plaintiff shareholders attempting to hold the director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company. [The court the cites and discusses the Business Judgement rule] [The court notes that under Caremark and under due care with a 102b7 provision the standard is the same: plaintiff must show bad faith. A plaintiff can show bad faith conduct by, for example, properly alleging particularized facts that show that a director consciously disregarded an obligation to be reasonably informed about the business and its risks or consciously disregarded the duty to monitor and oversee the business.] *** The presumption of the business judgment rule, the protection of an exculpatory 102(b)(7) provision, and the difficulty of proving a Caremark claim together function to place an extremely high burden on a plaintiff to state a claim for personal director liability for a failure to see the extent of a company's business risk. To the extent the Court allows shareholder plaintiffs to succeed on a theory that a director is liable for a failure to monitor business risk, the Court risks undermining the well settled policy of Delaware law by inviting Courts to perform a hindsight evaluation of the reasonableness or prudence of directors' business decisions. Risk has been defined as the chance that a return on an investment will be different that expected. The essence of the business judgment of managers and directors is deciding how the company will evaluate the trade-off between risk and return. Businesses-and particularly financial institutions-make returns by taking on risk; a company or

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investor that is willing to take on more risk can earn a higher return. Thus, in almost any business transaction, the parties go into the deal with the knowledge that, even if they have evaluated the situation correctly, the return could be different than they expected. It is almost impossible for a court, in hindsight, to determine whether the directors of a company properly evaluated risk and thus made the right business decision.FN58 In any investment there is a chance that returns will turn out lower than expected, and generally a smaller chance that they will be far lower than expected. When investments turn out poorly, it is possible that the decision-maker evaluated the deal correctly but got unlucky in that a huge loss-the probability of which was very small-actually happened. It is also possible that the decision-maker improperly evaluated the risk posed by an investment and that the company suffered large losses as a result. Business decision-makers must operate in the real world, with imperfect information, limited resources, and an uncertain future. To impose liability on directors for making a wrong business decision would cripple their ability to earn returns for investors by taking business risks. Indeed, this kind of judicial second guessing is what the business judgment rule was designed to prevent, and even if a complaint is framed under a Caremark theory, this Court will not abandon such bedrock principles of Delaware fiduciary duty law. With these considerations and the difficult standard required to show director oversight liability in mind, I turn to an evaluation of the allegations in the Complaint. a. The Complaint Does Not Properly Allege Demand Futility for Plaintiffs' Fiduciary Duty Claims In this case, plaintiffs allege that the defendants are liable for failing to properly monitor the risk that Citigroup faced from subprime securities. While it may be possible for a plaintiff to meet the burden under some set of facts [emphasis added], plaintiffs in this case have failed to state a Caremark claim sufficient to excuse demand based on a theory that the directors did not fulfill their oversight obligations by failing to monitor the business risk of the company. The allegations in the Complaint amount essentially to a claim that Citigroup suffered large losses and that there were certain warning signs that could or should have put defendants on notice of the business risks related to Citigroup's investments in subprime assets. Plaintiffs then conclude that because defendants failed to prevent the Company's losses associated with certain business risks, they must have consciously ignored these warning signs or knowingly failed to monitor the Company's risk in accordance with their fiduciary duties. Such conclusory allegations, however, are not sufficient to state a claim for failure of oversight that would give rise to a substantial likelihood of personal liability, which would require particularized factual allegations demonstrating bad faith by the director defendants. Plaintiffs do not contest that Citigroup had procedures and controls in place that were designed to monitor risk. [emphasis added] Plaintiffs admit that Citigroup established the ARM Committee and in 2004 amended the ARM Committee charter to include the fact that one of the purposes of the ARM Committee was to assist the board in fulfilling its oversight responsibility relating to policy standards and guidelines for risk assessment and risk management. **** According to plaintiffs' own allegations, the ARM Committee met eleven times in 2006 and twelve times in 2007. Plaintiffs nevertheless argue that the director defendants breached their duty of oversight either because the oversight mechanisms were not adequate or because the director defendants

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did not make a good faith effort to comply with the established oversight procedures. [Plaintiff claims there were red flags board didnt respond to, which all related to things happening out in the subprime mortgage marketnot Citibank specific issues]*** The warning signs alleged by plaintiffs are not evidence that the directors consciously disregarded their duties or otherwise acted in bad faith; at most they evidence that the directors made bad business decisions. The red flags in the Complaint amount to little more than portions of public documents that reflected the worsening conditions in the subprime mortgage market and in the economy generally. Plaintiffs fail to plead particularized facts suggesting that the Board was presented with red flags' alerting it to potential misconduct at the Company. That the director defendants knew of signs of a deterioration in the subprime mortgage market, or even signs suggesting that conditions could decline further, is not sufficient to show that the directors were or should have been aware of any wrongdoing at the Company or were consciously disregarding a duty somehow to prevent Citigroup from suffering losses. **** Indeed, plaintiffs' allegations do not even specify how the board's oversight mechanisms were inadequate or how the director defendants knew of these inadequacies and consciously ignored them. Rather, plaintiffs seem to hope the Court will accept the conclusion that since the Company suffered large losses, and since a properly functioning risk management system would have avoided such losses, the directors must have breached their fiduciary duties in allowing such losses. To recognize such claims under a theory of director oversight liability would undermine the long established protections of the business judgment rule. It is well established that the mere fact that a company takes on business risk and suffers losses-even catastrophic losses-does not evidence misconduct, and without more, is not a basis for personal director liability.20 That there were signs in the market that reflected worsening conditions and suggested that conditions may deteriorate even further is not an invitation for this Court to disregard the presumptions of the business judgment rule and conclude that the directors are liable because they did not properly evaluate business risk. What plaintiffs are asking the Court to conclude from the presence of these red flags is that the directors failed to see the extent of Citigroup's business risk and therefore made a wrong business decision by allowing Citigroup to be exposed to the subprime mortgage market. This Court's recent decision in American International Group, Inc. Consolidated Derivative Litigation demonstrates the stark contrast between the allegations here and allegations that are sufficient to survive a motion to dismiss. In AIG, the Court faced a motion to dismiss a complaint that included well-pled allegations of pervasive, diverse, and substantial financial fraud involving managers at the highest levels of AIG. In concluding that the complaint stated a claim for relief under Rule 12(b)(6), the Court held that the factual allegations in the complaint were sufficient to support an inference that AIG executives running those divisions knew of and approved much of the wrongdoing. The Court reasoned that huge fraudulent schemes were unlikely to be perpetrated without the knowledge of the executive in charge of that division of the company. Unlike the allegations in this case, the defendants in AIG allegedly failed to FN72. See Gagliardi v. TriFoods Int'l, Inc., 683 A.2d 1049, 1051 (Del.Ch.1996) (The business outcome of an investment project that is unaffected by director self-interest or bad faith, cannot itself be an occasion for director liability.) (footnote omitted)
20

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exercise reasonable oversight over pervasive fraudulent and criminal conduct. Indeed, the Court in AIG even stated that the complaint there supported the assertion that top AIG officials were leading a criminal organization and that [t]he diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is extraordinary. 21 **** IV. CONCLUSION Citigroup has suffered staggering losses, in part, as a result of the recent problems in the United States economy, particularly those in the subprime mortgage market. It is understandable that investors, and others, want to find someone to hold responsible for these losses, and it is often difficult to distinguish between a desire to blame someone and a desire to force those responsible to account for their wrongdoing. Our law, fortunately, provides guidance for precisely these situations in the form of doctrines governing the duties owed by officers and directors of Delaware corporations. This law has been refined over hundreds of years, which no doubt included many crises, and we must not let our desire to blame someone for our losses make us lose sight of the purpose of our law. Ultimately, the discretion granted directors and managers allows them to maximize shareholder value in the long term by taking risks without the debilitating fear that they will be held personally liable if the company experiences losses. This doctrine also means, however, that when the company suffers losses, shareholders may not be able to hold the directors personally liable. For the foregoing reasons, the motion to dismiss or stay in favor of the New York Action is denied. Defendants' motion to dismiss is denied as to the claim in Count III of the Complaint for waste for approval of the November 4, 2007 Prince letter agreement. All other claims in the complaint are dismissed for failure to adequately plead demand futility pursuant to Court of Chancery Rule 23.1.

21

FN75. It is also significant that the AIG Court was analyzing the Complaint under the plaintiff-friendly standard of Rule 12(b)(6), rather than the particularized pleading standard of Rule 23.1.

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Gantler [This is the courts discussion in Gantler of whether the directors were interested.] B. The Court of Chancery Misapplied the Business Judgment Standard The plaintiffs next claim that the legal sufficiency of Count I should have been reviewed under the entire fairness standard. That claim is assessed within the framework of the business judgment standard, which is "a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." Procedurally, the plaintiffs have the burden to plead facts sufficient to rebut that presumption. **** We first consider the sufficiency of Count I as against the Director Defendants. That Count alleges that those defendants (together with non-party director Zuzolo) improperly rejected a value-maximizing bid from First Place and terminated the Sales Process. Plaintiffs allege that the defendants rejected the First Place bid to preserve personal benefits, including retaining their positions and pay as directors, as well as valuable outside business opportunities. The complaint further alleges that the Board failed to deliberate before deciding to reject the First Place bid and to terminate the Sales Process. Indeed, plaintiffs emphasize, the Board retained the Financial Advisor to advise it on the Sales Process, yet repeatedly disregarded the financial Advisor's advice. A board's decision not to pursue a merger opportunity is normally reviewed within the traditional business judgment framework. In that context the board is entitled to a strong presumption in its favor, because implicit in the board's statutory authority to propose a merger, is also the power to decline to do so. Our analysis of whether the Board's termination of the Sales Process merits the business judgment presumption is two pronged. First, did the Board reach its decision in the good faith pursuit of a legitimate corporate interest? Second, did the Board do so advisedly? FN30 For the Board's decision here to be entitled to the business judgment presumption, both questions must be answered affirmatively. We consider first whether Count I alleges a cognizable claim that the Board breached its duty of loyalty. In TW Services v. SWT Acquisition Corporation, the Court of Chancery recognized that a board's decision to decline a merger is often rooted in distinctively corporate concerns, such as enhancing the corporation's long term share value, or "a plausible concern that the level of debt likely to be borne by [the target company] following any merger would be detrimental to the long term function of th[at] [c]ompany." A good faith pursuit of legitimate concerns of this kind will satisfy the first prong of the analysis. Here, the plaintiffs allege that the Director Defendants had a disqualifying self-interest because they were financially motivated to maintain the status quo. A claim of this kind must be viewed with caution, because to argue that directors have an entrenchment motive solely because they could lose their positions following an acquisition is, to an extent, tautological. By its very nature, a board decision to reject a merger proposal could always enable a plaintiff to assert that a majority of the directors had an entrenchment motive. For that reason, the plaintiffs must plead, in addition to a motive to retain corporate control, other facts sufficient to state a cognizable claim that the Director Defendants acted disloyally.

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The plaintiffs have done that here. At the time the Sales Process was terminated, the Board members were Stephens, Kramer, Eddy, Zuzolo and Gantler. Only Gantler voted to accept the First Place merger bid. The pled facts are sufficient to establish disloyalty of at least three (i.e., a majority) of the remaining directors, which suffices to rebut the business judgment presumption. First, the Reclassification Proxy itself admits that the Company's directors and officers had "a conflict of interest with respect to [the Reclassification] because he or she is in a position to structure it in a way that benefits his or her interests differently from the interest of the unaffiliated stockholders." Second, a director-specific analysis establishes (for Rule 12(b)(6) purposes) that a majority of the Board was conflicted. Stephens: Aside from Stephens losing his long held positions as President, Chairman and CEO of First Niles and the Bank, the plaintiffs have alleged specific conduct from which a duty of loyalty violation can reasonably be inferred. Stephens never responded to Cortland's due diligence request. The Financial Advisor noted that Stephens' failure to respond had caused Cortland to withdraw its bid. Even after Cortland had offered First Niles an extension, Stephens did not furnish the necessary due diligence materials, nor did he inform the Board of these due diligence problems until after Cortland withdrew. Cortland had also explicitly stated in its bid letter that the incumbent Board would be terminated if Cortland acquired First Niles. From these alleged facts it may reasonably be inferred that what motivated Stephens' unexplained failure to respond promptly to Cortland's due diligence request was his personal financial interest, as opposed to the interests of the shareholders. That same inference can be drawn from Stephens' response to the First Place bid: Count I alleges that Stephens attempted to "sabotage" the First Place due diligence request in a manner similar to what occurred with Cortland. Thus, the pled facts provide a sufficient basis to conclude, for purposes of a Rule 12(b)(6) motion to dismiss, that Stephens acted disloyally. Kramer: Director Kramer's alleged circumstances establish a similar disqualifying conflict. Kramer was the President of William Kramer & Son, a heating and air conditioning company in Niles that provided heating and air conditioning services to the Bank. It is reasonable to infer that Kramer feared that if the Company were sold his firm would lose the Bank as a client. The loss of such a major client would be economically significant, because the complaint alleges that Kramer was a man of comparatively modest means, and that his company had few major assets and was completely leveraged. Because Kramer would suffer significant injury to his personal business interest if the Sales Process went forward, those pled facts are sufficient to support a reasonable inference that Kramer disloyally voted to terminate the Sales Process and support the Privatization Proposal. Zuzolo: As earlier noted, Director Zuzolo was a principal in a small law firm in Niles that frequently provided legal services to First Niles and the Bank. Zuzolo was also the sole owner of a real estate title company that provided title services in nearly all of Home Federal's real estate transactions. Because Zuzolo, like Kramer, had a strong personal interest in having the Sales Process not go forward, the same reasonable inferences that flow from Kramer's personal business interest can be drawn in Zuzolo's case. In summary, the plaintiffs have alleged facts sufficient to establish, for purposes of a motion to dismiss, that a majority of the First Niles Board acted disloyally. *** Because the claim of disloyalty was subject to entire fairness review, the Court of Chancery erred in dismissing Count I as to the Director Defendants on the basis of the business judgment presumption.

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Melvin A. Eisenberg, Self-Interested Transactions in Corporate Law, 13 J. Corp. L. 997 (1988)

The duty of loyalty under corporate law is rooted in the duty of loyalty under agency law. In the classical agency paradigm, a single agent acts on behalf of a single principal. In the case of the corporation, the situation is structurally more complex. For example, a senior executive who enters into a self-interested transaction may deal with a subordinate, an equal, a superior, the board, or the shareholders. These structural complexities introduce a number of complexities into the legal analysis, the most significant of which concern the effect of approval by disinterested directors or shareholders, and the special case of compensation. Before getting to these complexities, I will examine the simple case, in which the approval of disinterested directors or shareholders is not obtained, and compensation is not involved. Under section 5.02 of the PRINCIPLES OF CORPORATE GOVERNANCE, this case is governed by a conjunctive test. The director or senior executive must make full disclosure (disclosure concerning the conflict of interest and the transaction) to the corporate decisionmaker who authorizes the transaction, and the transaction must be fair to the corporation. Why is it not sufficient to employ a disjunctive test, which would be satisfied if either the director or senior executive makes full disclosure or the transaction is done at a fair price? It's pretty easy to see, in the simple case, that the director or senior executive often could not conceivably satisfy the duty of loyalty simply by making full disclosure. Suppose, for example, that the director or senior executive makes full disclosure only to a subordinate. To take another case, suppose a corporation has aboard consisting of A, B, and C. A and B now enter into a selfinterested transaction that is approved 'by the board'--that is, by A and B--over C's objections. Clearly all the disclosure in the world by A and B to C should not make a dime's worth of difference if the transaction is unfair. But why isn't fairness of price enough without full disclosure? There are several answers to this question. To begin with, in all areas of the law full disclosure must be made by persons who are in a relation of trust and confidence with those with whom they deal. This requirement reflects the expectations one has when he deals with those with whom he has such a relationship. Moreover, a rule that fairness of price was enough without full disclosure would in effect remove decisionmaking from the corporation's hands and place it in the hands of the court. Many or most self-interested transactions involve differentiated commodities. Normally, one who purchases or sells a homogeneous commodity is a price-taker. If a commodity is homogeneous, it usually sells on the open market at a single price that is set on an objective basis and is publicly known. A purchaser or seller must take that price if he wants to purchase or sell the commodity. In the case of commodities that are differentiated, however, prices are invariably negotiated. The market may set outside limits on the price--at some point, the price the seller demands is so high that the buyer would prefer a market substitute, or the price the buyer insists upon is so low that the seller would prefer to market his commodity to someone else--but within those limits the price will be indeterminable prior to negotiation. Therefore, if by a 'fair price' we mean the price that would have been arrived at by a buyer and a seller dealing at arm's length, in the case of a self-interested transaction involving a differentiated commodity, a court attempting to determine whether the price was fair can do no more than to say that the price was or was not within the range at which parties dealing at arm's length would have concluded a deal. For example, a given office building might be fairly priced, in this sense, at

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anywhere from $40 million to $44 million, because any price within that range might have been arrived at by parties dealing at arm's length. Suppose that C Corporation purchases the office building for $42 million from a director or senior executive who has failed to disclose a material fact. The price may have been fair in the sense that third parties dealing at arm's length might have transacted at that price, but there is no way to know whether C would have paid $42 million if it had known the material fact. If there had been full disclosure, C might have agreed to purchase only at some price lower than $42 million. ... So much for the simple case. Suppose now that a self-interested transaction is approved by disinterested directors. Should such approval insulate a self-interested transaction from the application of a fairness test? Certainly, such approval would not affect the obligation to make full disclosure: approval of a self-interested transaction without the benefit of full disclosure is meaningless. The real question, therefore, is whether a self-interested transaction that has been approved by disinterested directors after full disclosure will still be subject to a test of fairness, or will simply be treated like a third-party transaction. There are two reasons why such a transaction should be subject to some sort of fairness test. First, directors, by virtue of their collegial relationships, are unlikely to treat one of their number with the degree of wariness with which they would approach a transaction with a third party. Second, it is difficult if not impossible to utilize a legal definition of disinterestedness in corporate law that corresponds with factual disinterestedness. A factually disinterested director would be one who had no significant relationship of any kind with either the subject matter of the self-interested transaction, or the director or senior executive who is engaging in the transaction, that would be likely to affect his judgment. It would, in short, be the disinterestedness we would expect from a fair-minded judge who is asked to recuse himself. For example, if a judge was the longtime friend of a party, the best man at his wedding, and the godfather of his child, we would expect him to recuse himself if he was fair-minded. For corporate-law purposes, however, it is desirable to define interestedness to include only financial and close familial relationship, because a corporate-law definition of disinterestedness that turned on factual disinterestedness would infect the business judgment rule. That rule protects only directors who are disinterested. If the corporate-law definition of disinterestedness corresponded to factual disinterestedness, the protection of the business judgment rule would be undesirably withheld from some directors who had no financial or close familial ties to a party to a transaction. ... There is another way in which this can be put: A review of the fairness of price of a self-interested transaction may be thought of as a surrogate for a review of the fairness of process by which the transaction was approved. If we lived in a world of perfect information, a court could always determine, by direct means, whether directors who approved a self-interested transaction were truly disinterested, approached the transaction with that degree of wariness with which they would approach transactions with third parties, were given appropriate counsel by the interested director or senior executive, and so forth. Because we don't live in such a world, the courts may need to make these determinations by indirect means. If a self-interested transaction that has been approved by 'disinterested' directors is substantively unfair, it can normally be inferred that either the approving directors were not truly disinterested, or that they were not as wary as they should have been because they were dealing with a colleague. Substantive unfairness may give rise to another important inference. It may suggest that even if the self-interested director or senior executive made full disclosure of all material facts, he withheld the counsel that he would have given if the transaction had been with a third

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party. The implications as to process that can be drawn from substantive unfairness are nicely illustrated by Justice Cordozo's well-known opinion in Globe Woolen v. Utica Gas & Electric Co. Globe Woolen had two steam-powered mills in Utica, which manufactured worsteds and woolens. Maynard was Globe's principal shareholder and president. He was also a director and chairman of the executive committee of Utica Gas & Electric Co.. Globe needed energy for several purposes, including operating and lighting its mills, heating the mills, and dyeing fabrics. Originally, the mills were operated and lit by steam that Globe generated in coal-fired steam boilers. Energy for heating and dyeing came from exhaust steam supplied by these boilers. Greenidge, who then was superintendent and later was general manager of Utica G&E, suggested to Maynard that Globe substitute electric power for steam to operate its mills. Steam would still be needed, however, for heating and dyeing. Originally, nothing came of the suggestion, because Maynard was afraid that the cost of the necessary new equipment would be too great unless Utica G&E would guarantee a saving in the cost of operation. Eventually, however, Greenidge and Maynard made long-term contracts covering both mills. Under these contracts, Utica G&E agreed to supply Globe with electricity at a designated maximum rate, and guaranteed that Globe's cost of electricity for operating and lighting the mills, plus Globe's cost of coal for heating and dyeing, would be $300 less per month than Globe's prior cost of coal for operating and lighting the mills and heating and dyeing. After the contracts had been made, Maynard laid them before Utica G&E's executive committee, where they were adopted by a vote of disinterested directors. The contracts turned out to be disastrous for Utica G&E. When the mills had been operated by steam, heating and dyeing involved little incremental cost, because Globe simply used excess steam from its steam-power generators. Now that the mills were operated by electricity, steam for heating and dyeing had to be generated by Globe as an independent coalfueled operation, and producing the steam in this way was much more expensive than using byproduct steam. Furthermore, Globe began dyeing more yarn in relation to slubbing (a kind of thread that is spun into yarn) than before. The dyeing of yarn took twice as much heat--again, coal heat--as the dyeing of slubbing, and thus doubled Utica G&E's fuel costs. These and like changes in the output of the mills had not been foreseen by Greenidge. The net result was that five years after the contracts had been made, Utica G&E had supplied Globe with electricity worth $60,000-$69,000, had been paid and was owed nothing, and itself owed Globe over $11,000 under the guarantee. If the contracts had run their full term, Utica G&E's loss would have been $300,000. It's hard to believe that Maynard did not foresee the potential for disaster to Utica G&E. Perhaps Maynard had the undisclosed intention when he made the contract of increasing the amount of yarn Globe dyed, but that was not found as a fact. Even if Maynard did not have that undisclosed intention, however, he failed to provide Utica G&E with his expert counsel concerning the implications of the contract: The trustee is free to stand aloof, while others act, if all is equitable and fair. He cannot rid himself of the duty to warn and to denounce, if there is improvidence or oppression, either apparent on the surface, or lurking beneath the surface, but visible to his practiced eye ... It is no answer to say that this potency [of profit], if obvious to Maynard, ought also have been obvious to other members of the committee. They did not know, as he did, the likelihood or the significance of changes in the business. There was need, too, of reflection and analysis

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before the dangers stood revealed. For the man who framed the contracts there was opportunity to consider and judge. His fellow members, hearing them for the first time, and trustful of his loyalty, would have no thought of latent peril. Unfairness of price was, therefore, evidence of unfairness of process, and although the contract had been approved by disinterested directors, the court held the contract could be rescinded. In sum, approval by disinterested directors should not insulate a self-interested transaction from judicial review for fairness. Nevertheless, approval by disinterested directors is not without meaning. Although the rule of section 5.02 is that approval by disinterested directors should not eliminate review for fairness, two significant effects are accorded to such approval. First, approval by disinterested directors shifts the burden of proof. Where a transaction has not been approved by disinterested directors, the burden of proof is on the selfinterested director or senior executive to show that the transaction was fair. Where there has been approval by disinterested directors, the burden of proof is on the complainant. Second, approval by disinterested directors changes the standard by which the selfinterested transaction is measured. The complainant must show that disinterested directors 'could not [have] reasonably . . . believed' the transaction to be fair to the corporation. This test is intended to be easier for the director or senior executive to satisfy than a pure fairness test, although harder to satisfy than the business-judgment standard. To achieve these two effects, the approval of disinterested directors must be given in advance. Later ratification will not do. Partly, this is based on the desirability of encouraging directors and senior executives to seek advance board approval of self-interested transactions. (Indeed, it looks peculiar when a director or senior executive engages in a transaction with the corporation without first going to the board.) Perhaps more important, if approval is sought before a transaction is entered into, the disinterested directors have the opportunity to negotiate with the senior executive or director. In contrast, if the self-interested director or senior executive merely seeks ratification after the fact, as a practical matter the opportunity for negotiation will typically not be present. Finally, if the director or senior executive does not seek approval of his self-interested transaction until it has been consummated, his colleagues are put on the spot. The question then before the board is not whether a proposed transaction is advantageous to the corporation, but whether a consummated transaction is so disadvantageous that a colleague should be exposed to a lawsuit. Questions on Eisenberg excerpt 1. Why should approval of a self-dealing transaction after full disclosure not always suffice to satisfy the duty of loyalty? 2. Eisenberg appears to celebrate the board in pressing for full disclosure but to deprecate the board in urging a modicum of fairness review in addition to disinterested director approval. Are these inconsistent positions? What is the problem with permitting judicial fairness review even where disinterested directors have authorized an interested transaction?

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Shareholder Suits22
Although the fiduciary duties of corporate officers and directors are sometimes enforced by the corporation itself (as when a new board or bankruptcy trustee sues departing management), by far the most important legal mechanism for enforcing fiduciary duties is the shareholder suit. Shareholder suits in the context of public corporations fall into two classes depending on the nature of their claims: direct suits (often brought as shareholder class actions) where a shareholder brings a suit against officers and directors (or the corporation) in her own name (as well as, in a class action, in the name of other shareholders); and derivative suits, which are actions against officers and directors (or third parties) brought on behalf of the corporation. The notion underlying this distinction is that shareholders might be injured either directly (in which case they should be entitled to sue directly and any damages would be paid to the shareholders directly) or indirectly as owners of the company (in which case any recovery from suit normally goes to the corporation and standing to sue must be reconciled with the board of directors' authority to manage the corporation). Many alleged breaches of fiduciary duty that occur during the normal operation of the corporation are conceptualized as injuries to the corporation, and therefore can only give rise to a derivative action. (Remember that fiduciary duties are owed to the corporation.) For this reason, this segment focuses on the derivative suit. A word of caution, however. In the merger context, violations of fiduciary duties often give rise to direct suits (alleging, in effect, that shareholders were directly harmed by a breach of fiduciary duties that resulted in shareholders receiving too little money or other consideration in the merger). To understand the derivative suit as an enforcement mechanism, it is helpful to step outside the doctrinal frame and ask what its functional elements are. There are three primary elements, of which only two are really important. The first (and unimportant) element is the set of standing requirements: Who is entitled to bring a derivative suit. Suffice to say here that a member of the plaintiff's bar is the real party of interest in most derivative litigation. Where a meritorious action exists, an enterprising plaintiff's lawyer can find a shareholder with standing to bring it. A second and much more important element of the derivative suit mechanism is the set of rules allocating the costs and benefits of suit: what the shareholder-plaintiff (or his lawyer) and the corporation stands to gain or lose when suit is brought. Obviously small shareholders in a public corporation face an enormous collective action problem in enforcing management's fiduciary obligations. Because litigation is costly, no small shareholder in a large corporation would ever sue on behalf of the corporation if the only reward were an increase in the value of the company's stock. The shareholder would bear the entire cost of litigation but gain, through his or her shareholdings, only a tiny fraction of the returns. It is the genius (or folly) of the American derivative suit and class action regimes to offer generous inducements to successful plaintiffs that typically far exceed out-of-pocket litigation expenses. This feature of the derivative suit explains the bounty-hunter character of the plaintiff's bar. Conversely, the absence of such compensation accounts in part for the scarcity of shareholder suits in other countries that provide a shareholder action for managerial misconduct.
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@ Marcel Kahan, 2008

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The third element of the derivative suit mechanism is a set of procedural screens or filters that can block many otherwise viable derivative suits: the so-called demand requirement, and the corporation's right to organize a special litigation committee of disinterested directors to evaluate derivative actions. Both of these procedural devices shift discretion over whether to pursue derivative litigation out of the hands of plaintiff-shareholders and into those of either courts, the boards of directors, or both. (Note that charter provisions that exclude entire classes of suits, such as Del. 102(b)(7), might be considered to be a screening device.) As you might expect, the success of derivative suits (and the class actions) as an enforcement mechanism is widely debated. Champions of the derivative suit lament efforts to tighten the legal screens, especially when these efforts give discretion over whether to pursue litigation to corporate directors -- who are regarded as "structurally biased" in favor of culpable managers. E.g., Dent, The Power of Directors to Terminate Shareholder Litigation: The Death of the Derivative Suit, 75 Northwestern L. Rev. 96 (1980). Opponents of derivative suits attack proposals that might reduce board discretion to screen derivative litigation. Dooley & Veasey, The Role of the Board in Derivative Litigation: Delaware Law and the Current ALI Proposals Compared, 44 Bus. Law. 503 (1989). In addition, many authors explore the related problems of frivolous derivative suits (so-called "strike suits") and of sweetheart settlements between plaintiffs' attorneys and corporate defendants that disregard the interests of the corporation and the shareholder body as a whole. See, e.g., Macey & Miller, The Plaintiffs' Attorney's Role in Class Actions and Derivative Litigation: Economic Analysis and Recommendations For Reform, 58 Chi. L. Rev. 1 (1991); Coffee, Understanding the Plaintiff's Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions, 86 Colum. L. Rev. 669 (1986). Somewhat surprisingly, however, the commentators have devoted little attention to the most basic issue concerning the derivative suit: How do the corporate costs and benefits of derivative litigation compare? Shareholders should have no cause to complain about who brings derivative suits as long as the suits that are brought, and the settlements or judgments that result, ultimately benefit shareholders. This raises the basic question: when should shareholders wish a derivative suit to be brought on behalf of the corporation against a manager who has violated her fiduciary duty? Presumably shareholders (and society) would prefer suits to be brought only when they will increase corporate value, i.e., when their benefits outweigh their costs. What elements figure into the costs and the benefits from derivative suits? How should these costs and benefits be allocated between the corporation (i.e. shareholders at large) and the shareholders who instituted the suit? As mentioned, the two most important screens for derivative suits are the demand requirement and the special litigation committee. Unlike procedural screens in general litigation, such as motions to dismiss on the pleadings or on summary judgment, these screens do not focus exclusively on the legal merits of derivative litigation. Rather, they focus on the business interests of the corporation and the authority of the board of directors (as opposed to the plaintiffshareholder) to control what is nominally the company's own course of action. In their present form, both the demand requirement and judicial doctrine on special litigation committees are largely judicial constructs. The demand requirement originates in the traditional procedural rule that a complaint in a derivative action must "allege with particularity the efforts, if any, made by the plaintiff to obtain the action he desires from the directors or comparable authority [of the corporation],.... and his reasons for his failure to obtain the action or for not

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making the effort." F.R.C.P. 23.1 (reprinted in your statutory supplement) Delaware has an identical state procedural rule. But the circumstances in which the complaint may be dismissed once the plaintiff does -- or does not -- make a demand on the board are controlled by common law. By contrast, there is no statutory basis at all for a procedure under which a court, upon the notion of a special committee of disinterested directors, may dismiss a derivative suit that is already underway. Nevertheless, state courts widely adopted this special litigation procedure under the pressure of growing numbers of shareholder suits in the 1970s and 1980s. The special litigation committee is now a standard feature of derivative suit doctrine even though, unlike the demand requirement, it is not triggered in every case.

The Demand Requirement

To institute a derivative suit, a shareholder must show either that demand on the board was futile (and thus excused) or that demand was wrongfully denied. The leading Delaware case Aronson v. Lewis, 473 A.2d 805 (Del. 1984), established the following test for demand futility: [I]n determining demand futility the Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Hence, the Court of Chancery must make two inquiries, one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board's approval thereof. As to the latter inquiry the court does not assume that the transaction is a wrong to the corporation requiring corrective steps by the board. Rather, the alleged wrong is substantively reviewed against the factual background alleged in the complaint. As to the former inquiry, directorial independence and disinterestedness, the court reviews the factual allegations to decide whether they raise a reasonable doubt, as a threshold matter, that the protections of the business judgment rule are available to the board. Certainly, if this is an "interested" director transaction, such that the business judgment rule is inapplicable to the board majority approving the transaction, then the inquiry ceases. Subsequent cases establish that it is sufficient to satisfy one of the two Aronson prongs. In the demand excused context, no actual demand on the board is ever made. Rather, a shareholder-plaintiff institutes a suit alleging that the Aronson test is satisfied and that demand is therefore futile. The company will invariably bring a motion to dismiss, arguing that the Aronson test is not satisfied. If the court agrees with the company, the case is dismissed. If the court agrees with the shareholder-plaintiff, the case can proceed, at least initially. (If demand is excused, the board retains the option of setting up a special litigation committee to investigate the suit. If the committee recommends dismissal, its recommendation is evaluated under Zapata. Necessarily, this can only happen if the court did not already dismiss the suit under Aronson.) The case that follows shows how the Aronson test is applied. Alternatively, a derivative suit can be instituted if the plaintiff shows that demand was wrongfully denied. To make that showing, the shareholder-plaintiff has to establish that the board failed to investigate reasonably whether bringing a suit is in the boards interest or that the board did not act in good faith. This showing is hard to make. Moreover, unlike in the demand excused context (where the shareholders never approaches the board before filing a complaint), in the demand wrongfully denied context, an actual demand on the board is made. In Delaware, by making such a demand, a shareholder is deemed to concede that the board is independent. Thus, if one makes demand (and the board denies the demand), one cannot turn around and argue, under Aronson, that

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demand was excused because the board lacked independence. Understandably, given this effect, shareholders are reluctant to make demand and prefer to argue that demand was excused. QUESTIONS ON THE DEMAND REQUIREMENT (1) Under Delaware law, what is the legal effect and likely consequence of a shareholder demand to the board that the board pursue a corporate cause of action? (2) Under Delaware law, when is demand excused? What must a plaintiff shareholder allege in her complaint to establish that demand is excused? How does the plaintiff find the necessary facts? (3) In a derivative suit in which the plaintiff seeks money damages from corporate officers, and in which the plaintiff is required to post a bond to pay the defendant's legal expenses if the defendant prevails, what justification is there for allowing the board to dismiss the suit? What does the corporation have to lose? (4) Doesn't a derivative suit always challenge the wisdom and judgment of the board? If you were a long time member of the board and a suit is filed challenging the behavior of other longtime members of the board, could you be fair and unbiased in deciding whether the suit should be dismissed? In a close case, how are you likely to vote? Assume you think that a suit has enough merit that it should go to the jury, yet you expect it will be dismissed. What consequences for your long-term relationship if you vote to allow the suit to proceed? Would it be worth it? What if you think the suit should succeed? (5) Suppose a plaintiff in a derivative action seeks recovery of funds embezzled by one of the corporation's officers and alleges with particularity the facts of the embezzlement and the failure of the board to seek recovery. Under Delaware law, is demand required? Should it be?

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Rales v Blasband Delaware Supreme Court Dec 23 1993 [Suit by shareholder of parent firm for actions of board of its controlled subsidiary in dealing with the parent. III. THE STANDARDS FOR DETERMINING WHETHER DEMAND IS EXCUSED IN THIS DERIVATIVE SUIT The stockholder derivative suit is an important and unique feature of corporate governance. In such a suit, a stockholder asserts a cause of action belonging to the corporation. Aronson, 473 A.2d at 811; Levine v. Smith, Del.Supr., 591 A.2d 194, 200 (1991). In a double derivative suit, such as the present case, a stockholder of a parent corporation seeks recovery for a cause of action belonging to a subsidiary corporation. *** Because directors are empowered to manage, or direct the management of, the business and affairs of the corporation, 8 Del.C. 141(a), the right of a stockholder to prosecute a derivative suit is limited to situations where the stockholder has demanded that the directors pursue the corporate claim and they have wrongfully refused to do so or where demand is excused because the directors are incapable of making an impartial decision regarding such litigation. **** Our decision in Aronson enunciated the test for determining a derivative plaintiffs compliance with this fundamental threshold obligation: whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Although these standards are well-established, they cannot be applied in a vacuum. Not all derivative suits fall into the paradigm addressed by Aronson and its progeny. The essential predicate for the Aronson test is the fact that a decision of the board of directors is being challenged in the derivative suit. Our discussion of the Aronson test in Pogostin v. Rice makes this clear: Directorial interest exists whenever divided loyalties are present, or a director has received, or is entitled to receive, a personal financial benefit from the challenged transaction which is not equally shared by the stockholders. The question of independence flows from an analysis of the factual allegations pertaining to the influences upon the directors performance of their duties generally, and more specifically in respect to the challenged transaction. The second, or business judgment inquiry of Aronson, focuses on the substantive nature of the challenged transaction and the boards approval thereof.*** Under the unique circumstances of this case, an analysis of the Boards ability to consider a demand requires a departure here from the standards set forth in Aronson. The Board did not approve the transaction which is being challenged by Blasband in this action. In fact, the Danaher directors have made no decision relating to the subject of this derivative suit. Where there is no conscious decision by directors to act or refrain from acting, the business judgment rule has no application. The absence of board action, therefore, makes it impossible to perform the essential inquiry contemplated by Aronsonwhether the directors have acted in conformity with the business judgment rule in approving the challenged transaction.

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Consistent with the context and rationale of the Aronson decision, a court should not apply the Aronson test for demand futility where the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit. This situation would arise in three principal scenarios: (1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where, as here, the decision being challenged was made by the board of a different corporation. Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile. [The ct notes that plaintiff would also have to satisfy the Aronson test in order to show that demand is excused on the subsidiary board, there is no need to create an unduly onerous test for determining demand futility on the parent board simply to protect against strike suits]. IV. WHETHER THE BOARD IS INTERESTED OR LACKS INDEPENDENCE In order to determine whether the Board could have impartially considered a demand at the time Blasbands original complaint was filed, it is appropriate to examine the nature of the decision confronting it [if the shareholder makes a demand]. ***The task of a board of directors in responding to a stockholder demand letter is a two-step process. First, the directors must determine the best method to inform themselves of the facts relating to the alleged wrongdoing and the considerations, both legal and financial, bearing on a response to the demand. If a factual investigation is required,11 it must be conducted reasonably and in good faith. Levine, 591 A.2d at 213; Spiegel v. Buntrock, Del.Supr., 571 A.2d 767, 777 (1990). Second, the board must weigh the alternatives available to it, including the advisability of implementing internal corrective action and commencing legal proceedings. *** In carrying out these tasks, the board must be able to act free of personal financial interest and improper extraneous influences.12 We now consider whether the members of the Board could have met these standards. A. Interest *** A director is considered interested where he or she will receive a personal financial benefit from a transaction that is not equally shared by the stockholders. Aronson, 473 A.2d at 812; Pogostin, 480 A.2d at 624. Directorial interest also exists where a corporate decision will have a materially detrimental impact on a director, but not on the corporation and the stockholders. In such circumstances, a director cannot be expected to exercise his or her independent business

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judgment without being influenced by the adverse personal consequences resulting from the decision. [Interest can include either interest in the underlying transaction or the threat of personal liability. For the latter, merely being sued is not enough] [But here the Third Circuit has already concluded that Blasband has pleaded facts raising at least a reasonable doubt that the [Easco boards] use of proceeds from the Note Offering was a valid exercise of business judgment. Blasband I, 971 F.2d at 1052. This determination is part of the law of the case, Blasband II, 979 F.2d at 328, and is therefore binding on this Court. Such determination indicates that the potential for liability is not a mere threat but instead may rise to a substantial likelihood. Therefore, a decision by the Board to bring suit against the Easco directors, including the Rales brothers and Caplin, could have potentially significant financial consequences for those directors. Common sense dictates that, in light of these consequences, the Rales brothers and Caplin have a disqualifying financial interest that disables them from impartially considering a response to a demand by Blasband. B. Independence Having determined that the Rales brothers and Caplin would be interested in a decision on Blasbands demand, we must now examine whether the remaining Danaher directors are sufficiently independent to make an impartial decision despite the fact that they are presumptively disinterested. As explained in Aronson, [i]ndependence means that a directors decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences. To establish lack of independence, Blasband must show that the directors are beholden to the Rales brothers or so under their influence that their discretion would be sterilized. We conclude that the amended complaint alleges particularized facts sufficient to create a reasonable doubt that Sherman and Ehrlich, as members of the Board, are capable of acting independently of the Rales brothers. Sherman is the President and Chief Executive Officer of Danaher [the controlled sub]. His salary is approximately $1 million per year. Although Shermans continued employment and substantial remuneration may not hinge solely on his relationship with the Rales brothers, there is little doubt that Steven Rales position as Chairman of the Board of Danaher and Mitchell Rales position as Chairman of its Executive Committee place them in a position to exert considerable influence over Sherman. In light of these circumstances, there is a reasonable doubt that Sherman can be expected to act independently considering his substantial financial stake in maintaining his current offices. Ehrlich is the President of Wabash National Corp. (Wabash). His annual compensation is approximately $300,000 per year. Ehrlich also has two brothers who are vice presidents of Wabash. The Rales brothers are directors of Wabash and own a majority of its stock through an investment partnership they control. As a result, there is a reasonable doubt regarding Ehrlichs ability to act independently since it can be inferred that he is beholden to the Rales brothers in light of his employment. Therefore, the amended complaint pleads particularized facts raising a reasonable doubt as to the independence of Sherman and Ehrlich. Because of their alleged substantial financial interest in

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maintaining their employment positions, there is a reasonable doubt that these two directors are able to consider impartially an action that is contrary to the interests of the Rales brothers. V. CONCLUSION We conclude that, under the substantive law of the State of Delaware, the Aronson test does not apply in the context of this double derivative suit because the Board was not involved in the challenged transaction. ***[T] he appropriate inquiry is whether Blasbands amended complaint raises a reasonable doubt regarding the ability of a majority of the Board to exercise properly its business judgment in a decision on a demand had one been made at the time this action was filed. Based on the existence of a reasonable doubt that the Rales brothers and Caplin would be free of a financial interest in such a decision, and that Sherman and Ehrlich could act independently in light of their employment with entities affiliated with the Rales brothers, we conclude that the allegations of Blasbands amended complaint establish that DEMAND IS EXCUSED on the Board. The certified question is therefore answered in the AFFIRMATIVE.

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In re China Agritech, Inc. Shareholder Derivative Litigation 2013 WL 2181514 (Del.Ch. 2013) China Agritech, Inc. ... purportedly operates a fertilizer manufacturing business in China. According to lead plaintiff Albert Rish, China Agritech is a fraud that serves only to enrich its co-founders, defendants Yu Chang and Xiao Rong Teng. Rish has sued derivatively to recover damages resulting from (i) the Company's purchase of stock from a corporation owned by Chang and Teng, (ii) the suspected misuse of $23 million raised by the Company in a secondary offering, (iii) the mismanagement that occurred during a remarkable twenty-four month period that witnessed the terminations of two outside auditing firms and the resignations of six outside directors and two senior officers, and (iv) the Company's failure to make any federal securities filings since November 2010 and concomitant delisting by NASDAQ. The defendants have moved to dismiss pursuant to Rule 23.1, contending that the complaint fails to plead that demand was made on the board or would have been futile. ... I. FACTUAL BACKGROUND A. China Agritech According to its public filings, China Agritech is a Delaware corporation that develops, manufactures, and markets environmentally friendly fertilizer products in the People's Republic of China. The Company accessed the domestic securities markets in February 2005 through a reverse merger with an inactive corporation that had retained its NASDAQ listing.* [U]sing a defunct Delaware corporation that happens to retain a public listing to evade the regulatory * [Eds.: When two or more corporations merge, only one of the constituent corporations survives. In a forward merger, which is by far the more common type, the acquiring company survives. In a reverse merger, by contrast, the acquired corporation is the one that survives. In such a merger, the newly formed entity retains all the rights of the surviving company, including its listing on a US stock exchange. By using this technique, a corporation thus can go public on US capital markets without the delay and expense of an initial public offering (IPO).] 20

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regime established by the federal securities laws is contrary to Delaware public policy. Williams v. Calypso Wireless, Inc., 2012 WL 424880, at *1 n. 1 (Del. Ch. Feb. 8, 2012). Defendant Chang founded China Agritech. Chang has served as the Company's President, Chief Executive Officer, Secretary, and Chairman of the board since February 2005. He owns approximately 55% of China Agritech's outstanding common stock, holding 34.1% directly and another 20.8% beneficially through China Tailong Group Limited. By virtue of his stock ownership and positions with the Company, Chang controls China Agritech. Defendant Teng co-founded China Agritech. Teng has served as a director of the Company since June 2005. From February 3, 2005 until March 13, 2009, she served as the Company's Chief Operating Officer. She owns 1.68% of the Company's common stock directly. B. Problems With Internal Controls In its [annual] Form 10K for the year ending December 31, 2007, filed with the SEC on March 28, 2008, the Company disclosed that it did not have in place the financial controls and procedures required to comply with U.S. financial reporting standards. In an effort to correct its control problems, the Company hired new executives and expanded its board. On October 22, 2008, defendant YauSing Tang (Y.Tang) joined China Agritech as its CFO and controller. On that same date, defendants Gene Michael Bennett, Lun Zhang Dai, and Hai Ling Zhang (H.Zhang) became directors. The board then established an Audit Committee, a Compensation Committee, and a Nominating and Governance Committee (the Governance Committee), each populated with the new outside directors. Beginning with its Form 10K for the year ending December 31, 2008, filed with the SEC on March 28, 2009, China Agritech disclosed that its internal controls and procedures were effective as of December 31, 2008. C. The Yinlong Transaction On February 12, 2009, Yinlong Industrial Co., Ltd. (Yinlong) sold China Agritech the remaining 10% equity interest in China Agritech's otherwise 90% owned subsidiary, Pacific Dragon Fertilizers Co. Ltd. (Pacific Dragon). Chang and Teng owned 85% and 15%, respectively, of Yinlong's shares, making the deal an interested transaction. . China Agritech acquired the Pacific Dragon shares through a wholly owned subsidiary, China Tailong Holdings Company Ltd. (Tailong). China Agritech agreed to pay Yinlong $7,980,000 for the shares, with all but $1 million coming in the form of an interest-free promissory note from Tailong to Yinlong. The transaction closed on May 15, 2009. On the day of the closing, the parties entered into a supplemental purchase agreement. The supplemental purchase agreement amended the settlement of the purchase consideration to a cash payment of $1 million and the issuance of 1,745,000 restricted shares of China Agritech common stock. Chang, Teng, Dai, Bennett, and H. Zhang comprised the board at the time of the Yinlong Transaction. Dai, Bennett, and H. Zhang comprised both the Audit Committee and the Governance Committee. 21

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In March 2009, defendant Ming Gang Zhu became China Agritech's Chief Operating Officer, taking over from Teng. In December 2009, defendant Zheng Wang joined the board as a designee of a fund that invested in the Company. Because of her affiliation, the board did not consider her to be an independent director. In early January 2010, Charles Law became an outside director. He joined the Governance Committee and the Compensation Committee. D. The $23 Million Offering In April 2010, China Agritech announced a public offering of 1,243,000 shares of common stock, plus an underwriter's option on an additional 186,450 shares, which the underwriter exercised (the Offering). The stated purpose of the Offering was to finance the construction of distribution centers for China Agritech's fertilizer products. The Offering raised total gross proceeds of $23 million. According to the Complaint, the funds have not been used to construct distribution centers or for any other discernible business purpose, suggesting either that the funds have been misused or that the stated purpose was false. At the time of the Offering, Chang, Teng, Dai, Bennett, H. Zhang, Law, and Wang comprised the board. E. The Material Weaknesses Return In its [quarterly] Form 10Q dated August 16, 2010, China Agritech disclosed that material weaknesses had again undermined its disclosure controls and procedures. The material weaknesses necessitated making adjustments to the Company's reported results for first quarter 2010. In its Form 10Q dated November 10, 2010, the Company claimed to have fixed its internal controls problem: [M]anagement enhanced the supervision and review of the financial reporting process and deemed that the remediation steps correct[ed] the material weaknesses previously identified. The November 2010 Form 10Q was the last time that China Agritech made a federally mandated securities filing. On November 13, 2010, three days after claiming that the material weaknesses were solved, the Company fired its outside auditor, Crowe Horwath LLP. The Audit Committee approved the termination. Dai, Bennett, and H. Zhang comprised the Audit Committee. F. The Company Hires Ernst & Young. Effective as of November 13, 2010, the Company hired Ernst & Young Hua Ming (Ernst & Young) as its new outside auditor On December 15, 2010, Ernst & Young provided a letter to the Audit Committee describing matters which, if not appropriately addressed, could result in audit adjustments, significant deficiencies or material weaknesses, and delays in the filing of the Company's Form 10K for 2010. Company management claimed to have addressed the issues, but Ernst & Young did not agree. 22

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G. The McGee Report While Ernst & Young was raising issues with Company management, Lucas McGee was investigating China Agritech. McGee is a self-described consultant and private investor with more than ten years of business and finance experience throughout Asia, including China, Hong Kong and Vietnam. On February 3, 2011, McGee posted a report titled China Agritech: A Scam (the McGee Report) on the investor website www.seekingalpha.com. McGee disclosed that he held a short position in the Company's stock and stood to profit from a decline in the Company's common stock price. The McGee Report identified a series of alleged problems with the Company's business, including: Factories are idle: After visiting [China Agritech's] reported manufacturing facilities ... we found virtually no manufacturing underway. The single exception was the facility in Pinggu County on the outskirts of Beijing, where the plant was not in operation on the Friday when we visited but local people told us that it has sporadically produced some liquid fertilizer over the last year. Plants in Bengbu, Anhui (supposedly the largest), Harbin, and Xinjiang were completely shuttered. Harbin plant for sale: The Harbin facilitysupposedly a major manufacturing facility for the $100 million revenue businesswhose name has never been officially changed in government documentation from Pacific Dragon, had a sign hanging on the gates last summer reading this factory is for sale. No contract with Sinochem: A January [China Agritech] announcement states: In May 2010, the Company signed a renewed contract supplying organic liquid compound fertilizers to Sinochem, China's largest fertilizer distributor. ... But a manager with Sinochem told us that Sinochem has no contract with [China Agritech] and in fact has never bought or sold organic liquid fertilizers.... [China Agritech] not permitted to make granular fertilizer: [China Agritech] claims that most of its sales volume now derives from granular compound fertilizers. But government officials familiar with the [China Agritech] operation say that [China Agritech] has not received a license to manufacture granular compound fertilizer and does not sell any. Unable to buy the product: Although the [C]ompany has announced 21 regional distribution centers, we have not been able to locate any. Fictional Revenue: [W]e have received an analysis of audited [China Agritech] revenues reported to the Chinese government for the year 2009 In its [third quarter 2010 10Q], [China Agritech] claims that it has 100,000 metric tons of production capacity in Anhui, 50,000 metric tons in Harbin, and 50,000 tons in Xinjiang. But a total value of ... $3,000 in plant and equipment in Xinjiang would be insufficient to support 50,000 tons of production capacity. Indeed, when we visited the site of the Xinjiang plant, we found little more than a warehouse, shared with two other companies and demonstrating no activity. Our early attempts to find the Xinjiang factory were unsuccessful.... [A]fter searching the area and asking county officials, we were able to discover a factory bearing [China Agritech's] name along with the names of two other companies [at a different location than the registered address] ....The facility, however, is idle and we were told by local people that there is no production activity there. 23

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In Anhui, which [China Agritech] calls its principal production facility ... [w]e visited and found a small plant on a rutted road outside Bengbu, completely deserted. The Beijing plant is larger, but plant staff said in our presence that the facility was idle. The [C]ompany would not allow us in, but we drove around the plant and saw a few people on site washing clothes but no evidence of production. Local government officials said that [China Agritech] had not been able to obtain a production license for granular fertilizer and that it produced a very small volume of liquid fertilizer. No distribution centers: In May 2010, [China Agritech] issued over 1.4 million new shares, raising just under $19 million for the construction of distribution centers. But we have not been able to find evidence that any distribution centers were actually built. Mysterious suppliers: The companies that [China Agritech] lists in its corporate materials as suppliers of raw materials ... cannot be found in any directory under possible Chinese names that would correspond to the transliterated names or under the alphabetic names. Financial anomalies: 3. The Xinjiang company reports zero fixed assets, meaning that it owns no equipment for production.... 4. The Beijing facility has licensed registered capital of $20 million, but by the end of 2009 had received 88 million RMB, so only more than half of the legally required amount. But despite the missing capital, half of the registered capital was still sitting in the account in cash in 2009, indicating that the company had not purchased much, if any, equipment. ... McGee concluded that China Agritech is not a currently functioning business that is manufacturing products. Instead it is, in our view, simply a vehicle for transferring shareholder wealth from outside investors into the pockets of the founders and inside management. On February 4, 2011, the day after the McGee Report issued, the Company posted a press release on its website denying the allegations. On February 10, the Company issued a second press release in the form of an open letter from Chang to Fellow Shareholders and Potential Investors in which he contested key elements of the McGee Report. On February 10, 2011, Law resigned from the board. The remaining directors appointed X. Zhang to fill his seat. H. The Company Fires Ernst & Young. On March 8, 2011, Ernst & Young met with the Audit Committee to discuss potential violations of law, including the United States securities laws. The issues identified by Ernst & Young included goods delivery notes that appeared to be modified after the fact; time sheets and related data for the Harbin facility that appeared to be destroyed; material purchases apparently made without supporting official tax invoice or with duplicative official tax invoice; a tax notice 24

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from the Harbin City tax bureau that appeared to be falsified; and what appeared to be material undisclosed related party transactions. Ernst & Young expressed concern about whether the firm could continue to rely on management's representations. ... Ernst & Young asked the Audit Committee to take timely and appropriate action. On March 10, 2011, the board formed a Special Investigation Committee (the Special Committee) to investigate Ernst & Young's allegations. The original members of the Special Committee were Wang, Dai, Bennett, and H. Zhang. Because Dai, Bennett, and H. Zhang were members of the Audit Committee, they faced the awkward task of investigating, evaluating, and passing on the propriety of their own actions as members of the Audit Committee. Wang was the only member of the Special Committee who did not face the prospect of investigating her own actions, but she was also a director whom the board did not regard as independent. On March 12, 2011, Company management drafted a press release stating that the Special Committee had been formed and explaining that the action was taken due to allegations made by third parties with respect to the Company and certain issues identified in connection with the performance of the Company's year end audit. When the actual press release was issued, it omitted the phrase identified in connection with the performance of the Company's year end audit. Ernst & Young immediately advised Company counsel that the deletion of the reference to audit issues was a material omission. Ernst & Young stated that it would resign if a corrective press release was not issued. No correction was made. On March 14, 2011, Chang informed Ernst & Young that the Audit Committee had terminated its engagement. Ernst & Young had no prior notice regarding its potential termination and had no reason to believe its termination was under consideration before the dispute over the press release. On March 15, 2011, Ernst & Young sent the Company a letter detailing its concerns about its termination and the accuracy of the Company's purported reasons. The letter noted that it was being sent to fulfill Ernst & Young's obligations under Section 10A(b)(2) of the Securities Exchange Act of 1934, which requires an independent auditor to report directly to a company's board of directors if it believes an (i) illegal act has occurred that materially affects the issuer's financial statements and (ii) that management had not, either independently or as required by the board, yet taken timely and appropriate remedial action. Wang, the chair of the Special Committee, resigned from the board on March 15, 2011. She was a Special Committee member only for one day. Def. Op. Br. at 38 n. 14. The other members of the Special Committee continued to serve. Bennett, the Chair of the Audit Committee, took over as Chair of the Special Committee. On April 25, 2011, the remaining directors appointed defendant Kai Wai Sim to fill Wang's seat. On the same day, Bennett resigned from both the Audit Committee and Special Committee, although for the time being he remained a member of the board. In April 2011, NASDAQ notified the Company that it would be delisted based on public interest concerns and the Company's failure to file its 2010 form 10K on time. On May 27, 2011, the Company announced that Zhu, the Company's COO, had resigned. ... 25

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J. The Special Committee's Findings On December 1, 2011, the Company issued a press release announcing that the Special Committee had completed its investigation. The Company noted that [t]he investigation was subject to certain limitations, including that [Ernst & Young] did not cooperate with the investigation.... It is not clear what other limitations, if any, existed. Without providing any details or explanation, the Company reported that according to the Special Committee, all was well: [T]he [Special] Committee concluded that the investigation appropriately addressed all material issues raised by [Ernst & Young], the circumstances of [Ernst & Young]'s termination, and the allegations in [the McGee Report]. With specific regard to [the McGee Report], the [Special] Committee concluded that the allegations were either factually incorrect or that there were reasonable explanations as to their non-materiality. K. The Parade Of Resignations On January 6, 2012, Rish filed this lawsuit. At the time, defendants Chang, Teng, Dai, Sim, Bennett, H. Zhang, and X. Zhang comprised the board (the Demand Board). Sim, Dai, H. Zhang, and X. Zhang served on the Special Committee, and Sim, H. Zhang, and X. Zhang served on the Audit Committee. [Shortly thereafter, Sim, Y.Tang, H. Zhang, X. Zhang, and Bennett resigned from the board.] ... The resignations left Chang, Teng, and Dai as the only members of the board. To recapitulate, Chang and Teng are the Company's co-founders. Chang controls a mathematical majority of China Agritech's outstanding voting power, and he is the Company's President, CEO, Secretary, and Chairman of the Board. II. LEGAL ANALYSIS A. Rule 23.1 When a corporation suffers harm, the board of directors is the institutional actor legally empowered under Delaware law to determine what, if any, remedial action the corporation should take, including pursuing litigation against the individuals involved. A cardinal precept of the General Corporation Law of the State of Delaware is that directors, rather than shareholders, manage the business and affairs of the corporation. Aronson v. Lewis, 473 A.2d 805, 811 (Del.1984). In a derivative suit, a stockholder seeks to displace the board's authority over a litigation asset and assert the corporation's claim. Aronson, 473 A.2d at 811. Because directors are empowered to manage, or direct the management of, the business and affairs of the corporation, the right of a stockholder to prosecute a derivative suit is limited to situations where the stockholder has demanded that the directors pursue the corporate claim and 26

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they have wrongfully refused to do so or where demand is excused because the directors are incapable of making an impartial decision regarding such litigation. Rish concedes that he did not make a litigation demand on the Demand Board, and the Company opposes his efforts to pursue litigation. Consequently, for Rish to obtain authority to move forward on behalf of China Agritech, his Complaint must allege with particularity ... the reasons ... for not making the effort [to make a litigation demand], and this Court must determine based on those allegations that demand is excused because the directors are incapable of making an impartial decision regarding whether to institute such litigation. Stone v.. Ritter, 911 A.2d 362, 367 (Del.2006). ... The Delaware Supreme Court has established two tests for determining whether the allegations of a complaint sufficiently plead demand futility. In Aronson, the seminal demand-futility decision, the Delaware Supreme Court crafted a specific two-part test that applies when a derivative plaintiff challenges an earlier board decision made by the same directors who remain in office at the time suit is filed. The Court of Chancery must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. [Aronson, 473 A.2d at 814.] The first of the two inquiries examines the independence and disinterestedness of the directors with respect to the decision that the derivative action would challenge. Id.* If the underlying transaction was approved by a disinterested and independent board majority, then the court moves to the second inquiry: whether the plaintiff has alleged facts with particularity which, if taken as true, support a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment. Id. at 815. A plaintiff might allege sufficiently, for example, that the directors were grossly negligent in approving the transaction. * [Eds.: Later in the opinon, the Vice Chancellor stated that: A director is deemed interested if he has received, or is entitled to receive, a personal financial benefit from the challenged transaction which is not equally shared by the stockholders. Pogostin v. Rice, 480 A.2d 619, 624 (Del .1984).] In [Rales v. Blasband, 634 A.2d 927 (Del.1993)], the Delaware Supreme Court confronted a board whose members had not participated in the underlying decision that the derivative action would challenge, and therefore the test enunciated in [Aronson ] ... [was] not implicated. [Id.] at 930. In response, the Delaware Supreme Court framed a second and more comprehensive demand futility standard that asks whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. Id. at 934. The Delaware Supreme Court envisioned that the Rales test would be used in three principal scenarios: (1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where ... the decision being challenged was made by the board of a different corporation. 27

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A director cannot consider a litigation demand under Rales if the director is interested in the alleged wrongdoing, not independent, or would face a substantial likelihood of liability if suit were filed. Rales, 634 A.2d at 936 (internal quotation marks omitted). To show that a director faces a substantial risk of liability, a plaintiff does not have to demonstrate a reasonable probability of success on the claim. In Rales, the Delaware Supreme Court rejected such a requirement as unduly onerous. Id. at 935. The plaintiff need only make a threshold showing, through the allegation of particularized facts, that their claims have some merit. Id. at 934. The Aronson and Rales have been described as complementary versions of the same inquiry. This case illustrates that reality. The fundamental question presented by the defendant's Rule 23.1 motion is whether the Demand Board could have validly considered a litigation demand. The Complaint challenges at least three events that involved actual decisions: the Yinlong Transaction, the terminations of the outside auditors, and the Special Committee's determination to take no action. Five of the seven members of the Demand Board were directors at the time those decisions were made. Because less than a majority of the directors making the decision have been replaced, Rales, 634 A.2d at 935, Aronson provides the demand futility standard for the five participating directors. Rales would provide the standard for the two remaining directors, but because the Aronson analysis establishes demand futility, I do not reach the Rales aspect. The litigation also alleges a systematic lack of oversight at China Agritech. That challenge does not involve an actual board decision, so Rales governs.* * [Eds.: Recall that earlier in the decision the court had explained that Rales applies where the subject of the derivative suit is not a business decision of the board. When plaintiff alleges a Caremark violation by the board for failing its oversight duties, by definition there has been no business decision and the second Rales prong is applicable.] The board of a Delaware corporation has a fiduciary obligation to adopt internal information and reporting systems that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board, each within its scope, to reach informed judgments concerning both the corporation's compliance with law and its business performance. In re Caremark Int'l Inc. Deriv. Litig., 698 A.2d 959, 970 (Del. Ch.1996). If a corporation suffers losses proximately caused by fraud or illegal conduct, and if the directors failed to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, then there is a sufficient connection between the occurrence of the illegal conduct and board level action or conscious inaction to support liability. Id. [I]mposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. Stone, 911 A.2d at 370. The burden on a plaintiff who seeks to establish liability under a failure-to-monitor theory is quite high. Caremark, 698 A.2d at 971. Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation, as in Graham [v. AllisChalmers Manufacturing Co., 188 A.2d 125 (Del.1963) ] or in [the Caremark case itself], ... only a sustained or systematic failure of the board to exercise oversightsuch as an 28

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utter failure to attempt to assure a reasonable information and reporting system existswill establish the lack of good faith that is a necessary condition to liability. Id. Concretely, this latter allegation might take the form of facts that show the company entirely lacked an audit committee or other important supervisory structures, or that a formally constituted audit committee failed to meet. [David B.] Shaev [Profit Sharing Account v. Armstrong], 2006 WL 391931, at *5 [(Del. Ch. Feb. 13, 2006)]. (footnote omitted). The allegations of the Complaint support a reasonable inference that China Agritech had a formally constituted audit committee [that] failed to meet. Shaev, 2006 WL 391931, at *5. In response to the Section 220 Demand, China Agritech did not produce any Audit Committee meeting minutes for 2009 or 2010. The Company's proxy statement filed on July 22, 2010 similarly implies that the Audit Committee did not meet during 2009, although it did take action by written consent on three occasions. During 2009 and 2010, the Company engaged in the Yinlong Transaction, conducted the Offering, disclosed a material weakness in its disclosure controls and procedures, claimed to have fixed the problem, terminated Crowe Horwath as its outside auditor, hired Ernst & Young as its new outside auditor, and named Dai's daughter as head of China Agritech's internal audit department. Yet there is no documentary evidence that the Audit Committee ever held a single meeting during this two year period. Discrepancies in the Company's public filings with governmental agencies reinforce the inference of an Audit Committee that existed in name only. During its time as a publicly listed entity in the United States, the federal securities laws mandated that the Company make periodic filings with the SEC. Regulatory requirements in China mandated that the Company make periodic filings with the State Administration for Industry and Commerce (SAIC). The Complaint alleges that in four of five years that the Company reported large profits in its filings with the SEC, the Company reported net losses to the SAIC. In the fifth year, the Company reported a large profit in its filings with the SEC, and one-fifth of that profit to the SAIC. Taken together, the factual allegations of the Complaint support a reasonable inference that the members of the Audit Committee acted in bad faith in the sense that they consciously disregarded their duties. Unlike the parade of hastily filed Caremark complaints that Delaware courts have dismissed, and like those rare Caremark complaints that prior decisions have found adequate, the Complaint supports these allegations with references to books and records ..., and with inferences that this Court can reasonably draw from the absence of books and records that the Company could be expected to produce. Because of their service on the Audit Committee, Dai, Bennett, and H. Zhang face a substantial risk of liability for knowingly disregarding their duty of oversight. These directors could not validly consider a litigation demand concerning the problems that occurred on their watch. Dai also could not validly consider a litigation demand for the additional reason that his daughter, Lingxiao Dai, served as Vice President of Finance from May 1, 2009 until November 19, 2010, and as head of the internal audit department thereafter. A director lacks independence when the director is unable to base his or her decisions on the corporate merits of the issue before the board. Litt v. Wycoff, 2003 WL 1794724, at *3 (Del. Ch. Mar. 28, 2003). A meaningful investigation into or litigation regarding China Agritech's lack of internal controls, 29

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financial reporting deficiencies, and potential violations of law would necessitate an investigation into Dai's daughter and could lead to a finding of wrongdoing against her. Close family relationships, like the parent-child relationship, create a reasonable doubt as to the independence of a director. Dai also cannot consider a demand that would place Chang or Teng at risk because his daughter's primary employment depends on the good wishes of the Company's controlling stockholders. Lastly, Chang could not validly consider a demand because he would face a substantial risk of liability in connection with the events of the 2009 through 2010 period. Chang was the Company's Chairman, CEO, and controlling stockholder. The disputes between the Company and Crowe Horwath and Ernst & Young pitted Chang and his management team against the outside auditors. Ernst & Young pointed the finger directly at Chang and his management team by advising the Audit Committee that it did not believe it could rely on management's statements. Ernst & Young also contended that it was senior management that made a materially misleading disclosure regarding Ernst & Young's termination. Chang, Dai, Bennett, and H. Zhang comprise a majority of the Demand Board. Demand is therefore futile under Rales for purposes of the Caremark claim, rendering it unnecessary to consider the other three directors. C. Section 102(b)(7)* *[Eds.: See supra Chapter 5, 1.] The defendants argue that the Complaint should be dismissed because it does not assert a claim for which the defendants could be held liable in light of the exculpatory provision in China Agritech's certificate of incorporation. Because the Complaint pleads claims that implicate the duty of loyalty, including its embedded requirement of good faith, the defendants cannot invoke the exculpatory provision as a defense at this stage. The Complaint challenges the Yinlong Transaction, an interested transaction with a controlling stockholder where entire fairness provides the presumptive standard of review. When the entire fairness standard of review applies, the inherently interested nature of those transactions renders the claims inextricably intertwined with issues of loyalty. Emerald P'rs v. Berlin, 787 A.2d 85, 93 (Del.2001). Chang and Teng benefitted directly from the Yinlong Transaction, and Dai, Bennett, and H. Zhang approved it. Given the standard of review, I cannot dismiss these defendants. The balance of the Complaint states claims that raise questions about whether the directors acted in good faith. A Section 102(b)(7) provision can exculpate directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith or a breach of the duty of loyalty. Stone, 911 A.2d at 367. The standard for Caremark liability parallels the standard for imposing liability when directors failed to act in good faith. See Stephen M. Bainbridge et al., The Convergence of Good Faith and Oversight, 55 UCLA L.Rev. 559 (2008) (discussing the reinterpretation of Caremark as a good faith case and the potential liability risks to directors that result). A failure to act in good faith may be shown, for instance, [1] where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the 30

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corporation, [2] where the fiduciary acts with the intent to violate applicable positive law, or [3] where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proven or alleged, but these three are the most salient. In re Walt Disney Co. Deriv. Litig, 906 A.2d 27, 67 (Del.2006) (quoting In re Walt Disney Co. Deriv. Litig, 907 A.2d 693, 75556 (Del. Ch.2005), aff'd, 906 A.2d 27 (Del.2006). The ruling that the Complaint states an oversight claim against the defendants prevents them from invoking the Company's exculpatory provision at the pleading stage. Questions 1. In this opinion, the court was resolving the defendant's motion to dismiss for failure to make demand. As the court noted in a portion we omitted, at that stage of the case, "plaintiffs receive the benefit of all reasonable inferences." If the case goes to trial, however, the court will be obliged to make credibility determinations. Is there any reason to be skeptical of elements of the plaintiff's evidence such as the McGee Report? 2. Although the Vice Chancellor stated that the Aronson and Rales tests are complementary versions of the same inquiry, the opinion also quotes Delaware Supreme Court precedents indicating that Aronson is not implicated where Rales applies and vice-versa. What are the differences between the Aronson and Rales standards and why did the Delaware Supreme Court create the latter standard to govern the specified cases? 3. In Rich v. Chong, 2013 WL 1914520 (Del. Ch. 2013), the Delaware Chancery Court faced a case, similar to China Agritech, involving a Chinese corporationFuqi International, Inc. that had accessed the US capital markets via a reverse merger into a US shell company listed on NASDAQ. In 2009, Fuqi announced that it would be unable to file its quarterly and annual SEC disclosure statements due to certain errors related to the accounting of the Companys inventory and cost of sales. In 2010, Fuqi disclosed that the SEC had begun an investigation of Fuqis failures to file SEC reports on a timely basis and other potential violations. Thereafter, Fuqi disclosed accounting errors, internal control failures, and other management problems. Plaintiff Rich brought a derivative suit alleging that Fuqis board of directors had violated its Caremark duties. The court explained that: One way a plaintiff may successfully plead a Caremark claim is to plead facts showing that a corporation had no internal controls in place. Fuqi had some sort of compliance system in place. For example, it had an Audit Committee and submitted financial statements to the SEC in 2009. However, accepting the Plaintiffs allegations as true, the mechanisms Fuqi had in place appear to have been woefully inadequate. In its press releases, Fuqi has detailed its extensive problems with internal controls. These disclosures lead me to believe that Fuqi had no meaningful controls in place. The board of directors may have had regular meetings, and an Audit Committee may have existed, but there does not seem to have been any regulation of the companys operations in China. Did China Agritech likewise have no meaningful controls in place, such that a Caremark case could be successfully pled? The Rich court further explained that: As the Supreme Court held in Stone v. Ritter, if the directors have implemented a system of controls, a finding of liability is predicated on the directors having consciously failed to monitor or oversee [the systems] operations thus disabling themselves from being informed of risks or problems requiring their attention. One way that the plaintiff may plead such a conscious failure to monitor is to identify red flags, obvious and problematic occurrences,

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that support an inference that the Fuqi directors knew that there were material weaknesses in Fuqis internal controls and failed to correct such weaknesses. First, Fuqi was a preexisting Chinese company that gained access to the U.S. capital markets through the Reverse Merger. Thus, Fuqis directors were aware that there may be challenges in bringing Fuqis internal controls into harmony with the U.S. securities reporting systems. Notwithstanding that fact, according to the Complaint, the directors did nothing to ensure that its reporting mechanisms were accurate. Second, the board knew that it had problems with its accounting and inventory processes by March 2010 at the latest, because it announced that the 2009 financial statements would need restatement at that time. In the same press release, Fuqi also acknowledged the likelihood of material weaknesses in its internal controls. Third, Fuqi received a letter from NASDAQ in April 2010 warning Fuqi that it would face delisting if Fuqi did not bring its reporting requirements up to date with the SEC. It seems reasonable to infer that, because of these red flags, the directors knew that there were deficiencies in Fuqis internal controls. Id. at *14 (footnotes omitted). Are there comparable red flags in China Agritech that would permit one to draw the same inference in that case? 4. If the directors in either China Agritech or Rich were aware that their companys internal controls were inadequate, have they failed to act in the face of a known duty such that they can be deemed to have acted in bad faith? 5. As to at least one of the transactions, namely the related party transaction between China Agritech and directors Chang and Teng, it appears that not all the directors were personally interested in the transaction. Can such directors nevertheless be held liable under Caremark even if they were not complicit in the underlying transaction? 6. As the China Agritech court indicates, Caremark claims are not exculpable under 102(b)(7) clauses. Why not? Should they be exculpable? 7. In cases like these, in which a corporation with the vast bulk of its operations in a foreign country becomes a US corporation via a reverse merger with a US shell corporation, and appoints US residents to the board of directors, what should those directors do to ensure that they comply with their duties as set forth in Stone v. Ritter, supra, and Francis v. United Jersey Bank, supra? Would you have been willing to serve as a director of China Agritech? What do you suppose motivates people to serve on the boards of such corporations?

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Effect of Dismissal on Subsequent Suits LOUISIANA MUNICIPAL POLICE EMPLOYEES RETIREMENT SYSTEM v. Pyott 46 A.3d 313 Court of Chancery of Delaware Decided June 11, 2012. Laster, Vice Chancellor [Background: Allergan, Inc. (Allergan) manufactures the muscle relaxant Botox. In a settlement with the United States Department of Justice on September 1, 2010, Allergan pleaded guilty to claims of misbranding and off-label marketing of Botox from 2000-2005. Allergan agreed to pay $600 million in criminal and civil fines, exceeding its net income in each of the previous two years and constituting 96% of its net income in 2010. Within days of the settlement, Louisiana Municipal Police Employees Retirement System (LAMPERS) commenced an action in Delaware, relying solely on public information and Allergans press release announcing the settlement, and later amended the complaint with additional public information. Within three weeks, three similar derivative suits were filed in the United States District Court for the Central District of California and were eventually consolidated (the California Litigation). Allergan moved to dismiss all complaints. In November of 2010, the U.F.C.W. Local 1776 & Participating Employment Pension Fund (UFCW) made a books and records demand on Allergan under 8 Del. C. 220 and moved to intervene in LAMPERS v. Pyott. ] Court opinion: On January 21, 2011, I denied the motion to intervene without prejudice as prematurely filed, but postponed any hearing on the motions to dismiss until after the 220 process is over. *** LAMPERS and UFCW then reached an accommodation permitting both to serve as co-plaintiffs. After pressing forward with its Section 220 demand, UFCW eventually obtained documents. The Delaware plaintiffs jointly filed the Complaint on July 8. The defendants moved to dismiss on July 15. Meanwhile, in the California Action, the California Federal Court dismissed the plaintiffs first complaint without prejudice on April 12, 2011. The California plaintiffs asked Allergan for the Section 220 production, and Allergan shared it. The California plaintiffs subsequently filed an amended complaint that incorporated the documents Allergan provided, and the California defendants again moved to dismiss. For reasons that are not clear to me, briefing on the motions to dismiss moved forward more quickly in California than in Delaware. On January 17, 2012, without the benefit of oral argument, the California Federal Court issued the California Judgment, a five-page order dismissing the California Action with prejudice pursuant to Rule 23.1 for failure to plead demand futility. *** The defendants then supplemented their motions to dismiss in this action to invoke collateral estoppel. Vice Chancellor Laster denied intervention without prejudice but stayed any decision on the motion to dismiss until completion of UFCWs review of Allergens books and records. Subsequently, LAMPERS and UFCW reached an agreement permitting both to serve as co-plaintiffs and filed an amended complaint, on July 8, 2011, based on information discovered through the books and records demand.

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II. LEGAL ANALYSIS The defendants identify three bases on which they say judgment should be entered in their favor: collateral estoppel, Rule 23.1, and Rule 12(b)(6). If collateral estoppel applies, then I need not consider the others, so I start there. A growing body of precedent holds that a Rule 23.1 dismissal has preclusive effect on other derivative complaints. These cases reason that because a stockholder plaintiff in a derivative action sues in the name of the corporation, all other stockholder plaintiffs are in privity with the plaintiff in the dismissed derivative action. In my view, the answer to the privity question turns on the legal relationship between a stockholder and the corporation, which is governed by Delaware law under the internal affairs doctrine. Controlling Delaware Supreme Court precedent makes clear that until a Rule 23.1 motion has been denied, a derivative plaintiff whose litigation efforts are opposed by the corporation does not have authority to sue in the name of the corporation. Consequently, at the time of the first Rule 23.1 dismissal, other stockholders are not in privity with the stockholder plaintiff in the first derivative action, and a decision granting a Rule 23.1 dismissal cannot have preclusive effect. The dismissal remains persuasive authority, but it is not preclusive. *** Because the California Judgment does not have preclusive effect, I analyze the defendants motions to dismiss pursuant to Rules 23.1 and 12(b)(6). Respectfully disagreeing with the California Federal Court, I deny the Rule 23.1 motion. With all reasonable inferences drawn in favor of the plaintiffs, as required at this procedural stage, the Complaints particularized allegations raise a reasonable doubt that a majority of the Board could properly consider a demand. Read as a whole, the particularized allegations support a reasonable inference that the Board consciously approved a business plan predicated on violating the federal statutory prohibition against off-label marketing. [O]ne cannot act loyally as a corporate director by causing the corporation to violate the positive laws it is obliged to obey. *** [I]t is generally accepted that a derivative suit may be asserted by an innocent stockholder on behalf of a corporation against corporate fiduciaries who knowingly caused the corporation to commit illegal acts and, as a result, caused the corporation to suffer harm. The Complaint therefore pleads a non-exculpated breach of the duty of loyalty, exposes the defendants to a substantial threat of liability, and renders demand futile. Determining that the Complaint alleges particularized facts that present a substantial threat of liability under the heightened Rule 23.1 pleading standard necessarily determines that the Complaint states a claim under the more plaintiff-friendly Rule 12(b)(6) standard. That motion is therefore denied as well. A. Collateral Estoppel **** 1. Choice of Law Whether successive stockholders are sufficiently in privity with the corporation and each other is a matter of substantive Delaware law governed by the internal affairs doctrine. *** ****Whether a stockholder in a Delaware corporation can sue derivatively after another stockholder attempted to plead demand futility should be governed uniformly by Delaware law.

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2. The Same Party Or A Party In Privity *** It is a matter of black-letter law that the plaintiff in a derivative suit represents the corporation, which is the real party in interest. *** Delaware law is in accord with the prevailing rule that the shareholder in a derivative suit represents the corporation.*** [Yet] as a matter of Delaware law, a stockholder whose litigation efforts are opposed by the corporation does not have authority to sue on behalf of the corporation until there has been a finding of demand excusal or wrongful refusal. *** The derivative plaintiffs lack of authority to sue on behalf of the corporation until the denial of a Rule 23.1 motion likewise flows from the two-fold nature of the derivative suit. As the Delaware Supreme Court explained in Aronson v. Lewis, the seminal demand-futility decision, [t]he nature of the [derivative] action is two-fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it. *** *** Under these controlling Delaware precedents, until the derivative action passes the Rule 23.1 stage, the stockholder does not have authority to assert the corporations claims and is not suing in the name of the corporation. Until a Rule 23.1 motion is denied or the board decides not to oppose the derivative action, the stockholder plaintiff is only suing to compel the corporation to sue. Aronson, 473 A.2d at 811. Put differently, the stockholder is asking the Court for authority to sue in the name of the corporation. **** In my view, therefore, the legal truism that the underlying claim in a derivative action belongs to the corporation and ultimately will be asserted in the corporations name if the stockholder plaintiff receives permission to sue does not support the proposition that stockholders are in privity for purposes of the preclusive effect of an order granting a Rule 23.1 motion. At that phase of the case, the competing stockholders are asserting only their individual claim to obtain equitable authority to sue. *** Courts giving preclusive effect to Rule 23.1 dismissals also have relied on generally accurate statements to the effect that a judgment in an action brought by or on behalf of the corporation binds all stockholders. **** This statement of black letter law certainly holds true when the plaintiff has authority to assert the corporations claims. **** The statement does not hold true when the stockholder plaintiff lacks authority to sue on behalf of the corporation, and it particularly does not hold true for a decision determining that the stockholder plaintiff lacks authority to sue. *** [Courts notes that a properly commenced and maintained representative action can bind subsequent plaintiffs but ] the authority to represent others is not conferred automatically by filing of complaint. A representative party must be granted ... authority, either by the represented party itself (in accordance with agency principles) or, in the class action context, by the court. Id. It is self-evident that if a litigant never seeks to and is never compelled to act in a representative capacity, the class of people that theoretically could have been represented by that litigant is in no way precluded from asserting their own claims in a subsequent proceeding. *** *** When a stockholder representative pursues claims in a derivative action, authority can be conferred in two ways. First, the board of directors or a duly empowered committee can approve the litigation expressly or by failing to oppose it. *** Second, and more commonly, a court can

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determine that the stockholder plaintiff has authority to proceed by denying a Rule 23.1 motion because the complaint adequately pleads either that demand should be excused as futile or that demand was made and wrongfully refused. When the same stockholder responds to a Rule 23.1 dismissal by attempting to file a second complaint alleging demand futility, the same party requirement is met and a Rule 23.1 dismissal may have preclusive effect. *** The same stockholder therefore cannot attempt to plead demand futility, lose, and then try again. This is also true as a matter of demand futility law. *** That the Delaware Supreme Court rendered its decision without mentioning collateral estoppel or res judicata suggests that the high court did not envision an expansive (if any) role for preclusion doctrine in the Rule 23.1 context.12 Consequently, when a different stockholder attempts to plead demand excusal, an earlier Rule 23.1 dismissal should not have preclusive effect. The earlier dismissal terminated the first phase of the prior derivative action, in which the complaining stockholder asserted an individual claim to seek equitable authority to sue on behalf of the corporation. **** This Court took a different approach in Career Education, a decision with which I respectfully disagree. Career Education followed the federal cases holding that a Rule 23.1 dismissal has broad preclusive effect.13 It summarized those decisions as follows: *** The Career Education decision thus assumed, as did the federal cases, that privity exists for purposes of a Rule 23.1 dismissal because the corporation is the true party in interest in a derivative suit. Id. As discussed, controlling Delaware Supreme Court authority dictates a contrary conclusion at the Rule 23.1 stage. *** In my view, contrary to Career Education, an earlier Rule 23.1 dismissal does not have preclusive effect on a subsequent derivative action brought by a different plaintiff because, as the earlier Rule 23.1 decision itself established, the prior plaintiff lacked authority to sue on behalf of the corporation and therefore was not in privity with the corporation or other stockholders. This does not mean that the Rule 23.1 decision has no value or, as several courts have posited, that demand futility could be relitigated ad infinitum.14 As Kohls makes clear, the earlier decision remains persuasive authority and could operate as stare decisis. When any other derivative plaintiff faces a Rule 23.1 motion involving the same transaction, the plaintiff must distinguish the new complaint or explain how the prior court erred such that the outcome of the motion would be different. I suspect that in many cases, the second court will follow the earlier ruling. 3. Inadequate Representation As an independent basis for declining to give collateral estoppel effect to the California Judgment, I find that the California plaintiffs did not adequately represent Allergan. The decisions that give preclusive effect to a Rule 23.1 dismissal universally recognize that another stockholder still can sue if the first plaintiff provided inadequate representation.15 Chancellor Strine has suggested Delaware law presume that a fast-filing stockholder with a nominal stake, who sues derivatively after the public announcement of a corporate trauma in an effort to shift the still-developing losses to the corporations fiduciaries, but without first conducting a meaningful investigation, has not provided adequate representation. *** When a derivative plaintiff files a damages action hastily in the wake of a public announcement,

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there is no basis for expediting the case to further the interests of the corporation and its stockholders, and, when the derivative plaintiff forewent a books and records investigation and a period of deep reflection on the publicly available documents and the law, should not the presumption be that the plaintiff is not fit to serve as the lead fiduciary for the corporation and its stockholders? What rational argument is there that it advances the legitimate interests of investors to give a leg up to the first to get to court in a situation when being first to court is likely to compromise the ability of the filing plaintiff to sustain his derivative complaint? Admittedly, there are no easy answers to the question of how to select lead counsel in representative actions, but what is certain is that rewarding plaintiffs and their counsel who sue first, and investigate and think second is likely to maximize the costs to investors of representative suits and minimize the benefits. Put simply, the speed racer approach might benefit certain interests, but those interests do not include the investors of corporations or the other societal constituencies dependent on the effective and efficient governance of corporations. **** b. The Idealized Derivative Action [The court then discusses how lawyers should proceed when filing a Caremark claim. The court first notes that Caremark claims require evidence of bad faith which means one will need corporate records]. Because a plaintiff must plead a connection to the board, only the extremely rare complaint will be able to establish the necessary linkage without referring to internal corporate documents. To obtain the necessary documents, the Delaware courts have long exhorted potential derivative plaintiffs to use Section 220 to investigate their claims and obtain corporate books and records before filing derivative litigation. The Delaware courts have dismissed a steady stream of Caremark claims where the plaintiffs have not first used Section 220 to obtain books and records.23 In bringing these actions, plaintiffs seem to hope the Court will accept the conclusion that since the Company suffered large losses, and since a properly functioning risk management system would have avoided such losses, the directors must have breached their fiduciary duties in allowing such losses. Citigroup, 964 A.2d at 129. The Delaware courts consistently have rejected such general ipse dixit syllogisms. Id. Not surprisingly, without first obtaining books and records, stockholders have not been able to link the trauma to the directors, and their Caremark complaints have been dismissed.24 By contrast, stockholders who have used Section 220 and obtained documents showing board consideration or involvement have been able to survive Rule 23.1 motions.25 Put simply, fast-filing generates dismissals. If dispersed stockholders could act collectively following a corporate trauma, they would want the corporation to pursue claims vigorously against its fiduciaries only if there was a riskadjusted prospect of a net-positive recovery. They would not file suit hastily, thereby imposing needlessly on themselves both the cost of their offensive litigation and the burdens of defense. The hypothetical stockholder collective would recognize there was no need to rush. The statute of limitations on a breach of fiduciary duty claim is three years. *** Rather than filing hastily, the hypothetical stockholder collective would proceed deliberately. It would hire well-qualified counsel. Through counsel, it would conduct an investigation and seek books and records using Section 220. After obtaining books and records, counsel would evaluate

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whether it made sense to sue. The books and records might show that the board had an appropriate monitoring system in place, but that the system did not alert the board. Or the books and records might show that despite their good faith efforts, the directors were misinformed or misled. Under these or other circumstances, the hypothetical stockholder collective logically might decide not to sue, preferring to leave their elected fiduciaries to the task of remedying the harm suffered by the corporation and dispensing with expensive litigation that likely would founder on Rule 23.1. If the stockholders had concerns, they might make a litigation demand, provide the board with the results of their investigation, and put the directors on notice. If the board declined to take action, the stockholders again could use Section 220 to investigate and consider a suit if the refusal was wrongful. By contrast, if the books and records showed director misconduct, then the stockholders could decide to pursue a claim. Their counsel at that point would be well positioned to plead demand futility and survive a motion to dismiss. Importantly for all concerned, the costly process of briefing and arguing motions to dismiss would take place once, based on the stockholders postinspection complaint. c. This Courts Efforts To Address Fast Filing *** In my view, a court in a plenary derivative action such as this one has discretion to address a rush to the courthouse by determining that the plaintiff in the original derivative action did not provide adequate representation for the corporation and declining on that basis to give preclusive effect to a Rule 23.1 dismissal of the fast-filers complaint. In this case, to give preclusive effect to the California Judgment would favor the lawyers who filed hastily, penalize the diligent counsel who used Section 220, and confer a case-dispositive advantage on the defendants at the potential expense of the corporation. **** [Analysis of this case]: By leaping to litigate without first conducting a meaningful investigation, the California plaintiffs firms failed to fulfill the fiduciary duties they voluntarily assumed as derivative action plaintiffs. Rather than seeking to benefit Allergan, they sought to benefit themselves by rushing to gain control of a case that could be harvested for legal fees. In doing so, the fast-filing plaintiffs failed to provide adequate representation. Subsequent events did not transform the fast-filing plaintiffs into adequate representatives. True, the defendants voluntarily provided the California plaintiffs with the Section 220 materials, after UFCW invested the time and resources to obtain them, and the California plaintiffs used the materials to file an amended complaint. But in my view, the fast-filing plaintiffs already had shown where their true loyalties lay. Asking for and receiving the benefit of another lawyers work did not rehabilitate them. It rather evidenced their continuing desire to control the case. In this regard, I disagree that the policy goal of encouraging plaintiffs to use Section 220 will not be undercut by a rule that affords priority to fast filers if the corporation gives them the same books and records that a diligent stockholder fought to obtain. But see Career Educ., 2007 WL 2875203, *10 n. 58 (asserting that policy of encouraging stockholders to use of Section 220 would not be undercut by allowing fast-filing plaintiffs to copy complaint prepared by stockholder who used Section 220 and then giving preclusive effect to dismissal in fast-filed action). Under the rule enunciated in King I, the issue would not arise because stockholders like the California plaintiffs would not be able to file fast, suffer dismissal, and then ask for books and records to try again.

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Assuming LeBoyer accurately states the law of collateral estoppel as I am bound to apply it (a point with which I disagree), the doctrine does not require dismissal in the current case because the plaintiffs in the California Action provided inadequate representation for Allergan. Rather than representing the best interests of the corporation, the California plaintiffs sought to maximize the potential returns of the specialized law firms who filed suit on their behalf. III. CONCLUSION *** Under my understanding of controlling Delaware Supreme Court precedent, collateral estoppel does not mandate dismissal. Separately and independently, by filing hastily and failing to conduct a meaningful investigation, the California plaintiffs acted self-interestedly and contrary to Allergans best interests. They did not provide adequate representation, rendering collateral estoppel inapplicable. **

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Seinfeld v Slager (Dela Chancery June 29, 2012 C. Demand Futility The Plaintiff challenges affirmative decisions by Republics board and has failed to make presuit demand; therefore, to show demand futility, under the well-known Aronson test, the Plaintiff must allege particularized facts that raise a reason to doubt that (1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Under the first prong of Aronson, a director is interested if he sits on both sides of a transaction or derives a benefit from a transaction that is not shared by the corporation or all stockholders generally. A director is not interested merely because he is named as a defendant in a suit, and generally, an inference of financial interest is not imputed to a director solely because he receives customary compensation for his board service. [Ed: emphasis added] When addressing Aronsons second prong, there is a presumption that the business judgment rule applies, and the plaintiff must rebut this presumption by pleading particularized facts to create a reasonable doubt that either (1) the action was taken honestly and in good faith or (2) the board was adequately informed in making the decision. D. Waste Demand may be excused under the second prong of Aronson if a plaintiff properly pleads a waste claim. In a derivative suit, this Court analyzes each of the challenged transactions individually to determine demand futility. The Plaintiff here alleges that he has adequately pled waste for each of his claims and that demand should be excused. [T]he doctrine of waste is a residual protection for stockholders that polices the outer boundaries of the broad field of discretion afforded directors by the business judgment rule. As such, a plaintiff faces an uphill battle in bringing a waste claim, and a plaintiff must allege particularized facts that lead to a reasonable inference that the director defendants authorized an exchange that is so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration. Where, however, the corporation has received any substantial consideration and where the board has made a good faith judgment that in the circumstances the transaction was worthwhile, a finding of waste is inappropriate, even if hindsight proves that the transaction may have been ill-advised. This Court has described the waste standard as an extreme test, very rarely satisfied by a shareholder plaintiff, because if under the circumstances any reasonable person might conclude that the deal made sense, then the judicial inquiry ends.21 The rationale behind these stringent requirements is that [c]ourts are ill-fitted to attempt to weigh the adequacy of consideration under the waste standard or, ex post, to judge the appropriate degrees of business risk.22

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CRAIG LONDON and JAMES HUNT, individually and derivatively on behalf of MA FEDERAL, INC., d/b/a iGov, a Delaware corporation, Plaintiffs, v. MICHAEL TYRRELL, PATRICK NEVEN, and WALTER HUPALO, Defendants, and MA FEDERAL, INC., d/b/a iGov, a Delaware corporation, Nominal Defendant. COURT OF CHANCERY OF DELAWARE March 11, 2010, Decided MEMORANDUM OPINION CHANDLER, Chancellor. After a four-month investigation of plaintiffs' claims in this derivative action, a special litigation committee (the "SLC") formed by nominal defendant iGov has recommended dismissal of plaintiffs' suit. I deny the SLC's motion to dismiss because there are material questions of fact regarding (1) the SLC's independence, (2) the good faith of its investigation, and (3) whether the grounds upon which it recommended dismissal of this lawsuit are reasonable. Accordingly, plaintiffs may continue to pursue this action. I. FACTS This dispute springs from the approval and implementation of an equity incentive plan on January 30, 2007 (the "2007 Plan") by defendants in their role as iGov directors. *** Q. iGov Forms a Special Litigation Committee after its Motion to Dismiss is Denied After plaintiffs' complaint was amended, defendants again filed a motion to dismiss on several grounds, including plaintiffs' failure to make a demand on the board before filing suit. In my June 24, 2008 Opinion, I found that plaintiffs' complaint "easily survived" defendants' motion to dismiss; demand being excused because a majority of the board was interested in the transaction. 30 Thereafter, on November 21, 2008, the iGov board voted to form a two-member SLC comprised of Salvatori and Vinter to consider whether it was in iGov's best interest to pursue the derivative claims in plaintiffs' complaint. After its formation, the SLC obtained advisors. In February 2009 the SLC engaged Blank Rome LLC as independent counsel and in March 2009 the SLC engaged Stout Risius Ross ("SRR") as its independent financial advisor. From April 2009 to July 2009 the SLC conducted its investigation. Discovery was stayed during this time. In conducting the investigation the SLC interviewed twelve witnesses and reviewed relevant documentation produced by the parties, iGov, Textron, Chessiecap, McLean, and others, including the documents provided to plaintiffs in response to their 220 action. To inform their investigation, the SLC sought counsel's advice as to the legal principles that determine whether defendants complied with their fiduciary duties. During the investigation, the SLC charged SRR with two tasks. First, SRR was instructed to perform independent valuations of iGov as of October 31, 2006 and as of January 30, 2007 (the "SRR Valuations"). The SLC required SRR to complete the SRR Valuations without reviewing the work done by Chessiecap and McLean, presumably to ensure that SRR would not be

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influenced by any previous valuation work performed. The SLC determined that October 31, 2006 was an appropriate valuation date because it believed that Chessiecap's Final [*33] Valuation was essentially current as of October 31, 2006, despite being dated July 31, 2006. 31 The SLC determined that January 30, 2007 was an appropriate date for more obvious reasons; it was the date the challenged 2007 Plan was adopted. I will discuss the SRR Valuations at greater length later but for now I note that the FY07 EBITDA forecast SRR used was the Tyrrell Baseline Forecast. The SRR Valuations concluded that iGov was worth $ 3.90 - $ 4.15 per share as of October 31, 2006 and $ 5.24 - $ 5.39 per share as of January 30, 2007. The SLC concluded that the $ 4.92 per share price was "within the range of fair market value" based on the SRR Valuations as well as Salvatori and Vinter's own professional experience in government contracting. 32 Notably, despite the SRR Valuations, the SLC reasoned that $ 4.92 per share "was likely too high, from a practical, real world perspective, to express the Company's value." 33 The second task SRR was charged with was to review the Chessiecap Final Valuation and the McLean Valuations and opine on them. SRR did this and helped the SLC prepare a summary comparison between the Chessiecap Valuation and McLean Valuations that was included in the SLC Report. The SLC concluded that both sets of valuations were "tainted" and reasoned that it was not necessary to determine which set of valuations was better. 34 The SLC concluded that it could make a recommendation respecting this suit and iGov's best interests without declaring a winner in the battle between plaintiffs' and defendants' experts. On August 5, 2009, the SLC Report was filed. The SLC Report concludes that the suit is not in the best interests of the Company and recommends that it be dismissed. The SLC believes that the discovery that will resume if the suit is allowed to continue will be extremely disruptive to iGov's operations. The SLC also believes that negative publicity associated with the suit will immediately damage the Company's goodwill and reputation in the government contracting community. As to the actual claims asserted in plaintiffs' complaint, the SLC Report concludes as follows. First, as to Count I, the SLC concluded that defendants acted properly in adopting the 2007 Plan and did not breach their duties of care or loyalty. With regards to the duty of care, the SLC found that the 8 Del. C. 102(b)(7) provision in iGov's certificate of incorporation exculpates directors from personal liability not involving intentional misconduct or knowing violations of the law. The SLC concluded that a duty of care claim should not be pursued because defendants breach of care conduct, if it occurred, would be covered by the 102(b)(7) provision. As to the duty of loyalty, the SLC concluded that defendants' approval of the 2007 Plan and actions leading to that approval would satisfy the entire fairness standard because the process employed was fair and the $ 4.92 strike price was fair. As to Count II the SLC determined that no rescission of the options granted and shares sold to defendants under the 2007 Plan should occur because $ 4.92 was in the range of fair market value. Finally, the SLC determined that Count III should be dismissed based on its belief that any dilution plaintiffs suffered was experienced equally by other shareholders and thus, no individual claim exists. [*36] Count III, according to the SLC, is a derivative claim arising out of the conduct alleged in Count I and should be dismissed for the same reasons that Count I should be dismissed. After reviewing the SLC Report plaintiffs filed an opposition brief arguing that the SLC has not met the standard required by Zapata Corporation v. Maldonado 35 and its progeny for dismissal of a claim based on an SLC's recommendation in a demand-excused case. I now consider whether the SLC has met the Zapata standard and, consequently, whether the suit should be dismissed or permitted to proceed.

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II. STANDARD The Supreme Court's decision in Zapata governs demand-excused derivative cases in which the board sets up an SLC that investigates whether a derivative suit should proceed and recommends dismissal after its investigation. 36 *** The Court treats the SLC's motion in a manner akin to a Rule 56 motion for summary judgment; the SLC bears the burden of demonstrating that there are no genuine issues of material fact as to its independence, the reasonableness and good faith of its investigation, and that there are reasonable bases for its conclusions. 42 If the Court determines that a material fact is in dispute on any of these issues it must deny the SLC's motion. 43 When an SLC's motion to dismiss is denied, control of the litigation is returned to the plaintiff shareholder. 44 With the relevant standard broadly articulated, I now proceed to step one of Zapata. III. ANALYSIS A. Were the SLC Members Independent? Whether an SLC member is independent "is a fact-specific determination made in the context of a particular case." 45 When an SLC member has no personal interest in the disputed transactions, the Court scrutinizes the members' relationship with the interested directors, as that would be the source of any independence impairment that might exist. 46 The Court considers the relationship between each SLC member and the interested directors. An SLC member does not have to be unacquainted or uninvolved with fellow directors to be regarded as independent. 47 But an SLC member is not independent if he or she is incapable, for any substantial reason, of making a decision with only the best interests of the corporation in mind. 48 Essentially, this means that the independence inquiry goes beyond determining whether SLC members are under the "domination and control" of an interested director. 49 Independence can be impaired by lesser affiliations, so long as those affiliations are substantial enough to present a material question of fact as to whether the SLC member can make a totally unbiased decision. For example, independence could be impaired if the SLC member senses that he owes something to the interested director based on prior events. 50 This sense of obligation need not be of a financial nature. 51 The independence inquiry under the Zapata standard has often been informed by case law addressing independence in the pre-suit demand context and vice-versa.232 This is a useful exercise but not one without limits. As the Supreme Court noted in Beam v. Stewart: Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be "like Caesar's wife"-"above reproach." Moreover, unlike the presuit demand context, the SLC analysis For example, in Oracle, a case governed by Zapata, after articulating what it means for an SLC member to be independent, the Court noted that "[t]his formulation is wholly consistent with the teaching of Aronson [a pre-suit demand case], which defines independence as meaning that 'a director's decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences." Oracle, 824 A.2d at 938 (citing Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984). Also, in the pre-suit demand case of Beam v. Stewart, 833 A.2d 961 (Del. Ch. 2003), the Court's independence analysis was informed by Oracle. Id. at 979.
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contemplates not only a shift in the burden of persuasion but also the availability of discovery into various issues, including independence. 53 Unlike a board in the pre-suit demand context, SLC members are not given the benefit of the doubt as to their impartiality and objectivity. They, rather than plaintiffs, bear the burden of proving that there is no material question of fact about their independence. The composition of an SLC must be such that it fully convinces the Court that the SLC can act with integrity and objectivity, because the situation is typically one in which the board as a whole is incapable of impartially considering the merits of the suit. 54 Thus, it is conceivable that a court might find a director to be independent in the pre-suit demand context but not independent in the Zapata context based on the same set of factual allegations made by the two parties. This is not because the substantive contours of the independence doctrine are different in these two contexts. Rather, it is primarily a function of the shift in the burden of proof from the plaintiff to the corporation when the suit moves from the pre-suit demand zone to the Zapata zone. It is undisputed that neither SLC member had a personal stake in the challenged transactions. Neither Salvatori nor Vinter received shares of stock or options under the 2007 Plan and neither faces any risk of personal liability in this suit. Moreover, Salvatori and Vinter were not appointed to the board until after the 2007 Plan was adopted. In addition, plaintiffs do not allege that any of the defendants dominate or control Salvatori or Vinter. Thus, the focus must be on whether the relationships Salvatori and Vinter have with defendants are of such a nature that they might have caused Salvatori and Vinter to consider factors other than the best interests of the corporation in making their decision to move for dismissal. Such a relationship would raise a material question as to the SLC's independence. After carefully reviewing the evidence produced by the limited discovery thus far permitted, I conclude that there is a material question of fact as to the independence of both SLC members based on their relationships to Tyrrell. I begin by discussing Vinter. Plaintiffs argue that Vinter's independence is impaired by one simple fact; Vinter's wife is Tyrrell's cousin. According to plaintiffs, it was that association that caused Tyrrell to approach Vinter about joining the iGov board. 24 Defendants counter that this familial relationship does not impair Vinter's independence because Tyrrell and Vinter's wife are not close cousins; they only occasionally cross paths at large family functions once or twice each year. Plaintiffs respond that, even though Tyrrell and Vinter's wife may not be particularly close, it would have been impossible for Vinter not to think of Tyrrell as "my wife's cousin" when grappling with the difficult decision of recommending whether civil litigation against him should proceed. According to plaintiffs, this is a sufficient connection to create an unacceptable risk of bias in Vinter's mind.25 Defendants cite Beam v. Stewart, a case in which the Supreme Court stated that "allegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a director's independence." 57 Defendants argue that, under Beam, the familial connection between Tyrrell and Vinter is simply not enough to raise a
The SLC Report did not reveal that Tyrrell extended the invitation to Vinter to join the iGov board. When Vinter was asked in his deposition how Tyrrell knew to call him, he initially stated "[y]ou'll have to ask [Tyrrell] that. I don't know." Vinter Dep. 20:14-15, Oct. 7, 2009. Plaintiffs' counsel then asked if Vinter knew who Tyrrell was when he called, to which Vinter responded "[w]ell, I mean, he's my wife's cousin" Id. at 20:20. 25 Id. at 947 (holding that independence under Zapata is not established where "the connections identified [between the SLC and the interested directors] would be on the mind of the SLC members in a way that generates an unacceptable risk of bias.").
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material question of fact as to Vinter's independence. I disagree. Beam was a pre-suit demand case, and the burden in that case was on the plaintiffs to allege facts sufficient to create a reasonable doubt that the board could not objectively consider a suit against its Chairman, Martha Stewart. In their complaint, the plaintiffs broadly alleged that Stewart had personal friendships or outside business dealings with certain of the directors. This was not enough, standing alone, to create a reasonable doubt about the ability of the directors to objectively consider the merits of a suit against Stewart. In this case, however, the burden is on iGov to show that it has appointed SLC members whose independence cannot seriously be doubted. The Company, not plaintiffs, must do the explaining in the first instance if there are associations that cast a shadow on independence. Frankly, appointing an interested director's family member to an SLC will always position a corporation on the low ground. From there, the corporation must fight an uphill battle to demonstrate that, notwithstanding kinship, there is no material question as to the SLC member's objectivity. Put simply, explaining away a familial association in Zapata territory is a more difficult challenge for a corporation than confronting a broad allegation of personal or business relationships in pre-suit demand territory. I admit that it is not possible, at this stage of the proceedings, to say unequivocally that Vinter's independence is impaired. On the one hand, the relationship between Vinter's wife and Tyrrell does not seem to be particularly close. They do not frequently associate with one another as some cousins are wont to do. On the other hand, they do see each other regularly, albeit infrequently, at family functions. For example, each year Vinter and his wife attend a large family party at Tyrrell's in honor of Tyrrell's mother, who has passed away. 58 Vinter also testified in his deposition that, while he did not see Tyrrell on a regular basis or personally discuss Tyrrell's work with him before joining the iGov board, he "sort of knew where he was at any given time . . . ." 59 Thus, the familial relationship appears to be close enough that Vinter has been kept apprised of Tyrrell's comings and goings through the family grapevine. To my mind, there is a material question of fact as to how much Vinter's family association with Tyrrell may have influenced his objectivity. I cannot say with certainty that Vinter would not have considered the potentially awkward situation of showing up to Tyrrell's annual party after the family rumor mill had spread the word that Vinter had recommended that a lawsuit should proceed against the host.26 60 Therefore, I am not convinced, as I must be under Zapata, that Vinter's recommendation would have been solely influenced by considerations of iGov's best interests. Now to Salvatori. Like Vinter, Salvatori's contact with iGov was based on an association with Tyrrell. In 1993, Tyrrell was hired by Salvatori to work as an internal auditor for a company called QuesTech. Salvatori was a QuesTech co-founder and served as its President, CEO, and
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Vice Chancellor Strine has made an important holding about the bearing of familial relationships on the independence inquiry. In a pre-suit demand case, plaintiff sought to carry its burden by alleging that a particular director was not independent, and could not impartially consider a demand, because he was the brother-in-law of an interested director. The Vice Chancellor held that "familial relationships between directors can create a reasonable doubt as to impartiality. The plaintiff bears no burden to plead facts demonstrating that directors who are closely related have no history of discord or enmity that renders the natural inference of mutual loyalty and affection unreasonable." Harbor Fin. Partners v. Huizenga, 751 A.2d 879, 889 (Del. Ch. 1999) (internal citations omitted). Thus, in the pre-suit demand context, plaintiffs can often meet their burden of establishing a lack of independence with a simple allegation of a familial relationship. Surely then, in the Zapata context, it will be nigh unto impossible for a [*48] corporation bearing the burden of proof to demonstrate that an SLC member is independent in the face of plaintiffs' allegation that the SLC member and a director defendant have a family relationship.

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Chairman while Tyrrell was employed there for six years. During that time, Salvatori promoted Tyrrell to CFO, in which role he reported directly to Salvatori. Tyrrell worked as QuesTech's CFO until it was sold in 1998. Tyrrell appears to have made a significant and valued contribution to the efforts to sell QuesTech. In his deposition, Salvatori testified that he has "a great respect for [Tyrrell]. And he was very helpful in helping me get a good price for my company. Very helpful." 61 Tyrrell's employment with QuesTech ended when it was sold. After the sale, Tyrrell and Salvatori maintained minimal connections. Their professional association was reinstated when Tyrrell approached Salvatori about joining the iGov board. As noted, the independence of an SLC member may be impaired if that member feels he owes something to an interested director. 62 That sense of obligation does not have to be financial in nature.63 In this case, I believe there is a material question of fact as to Salvatori's independence because his earlier associations with Tyrrell may have given rise to a sense of obligation or loyalty to him. Salvatori appears to have been satisfied with the price he received for QuesTech, and he continues to feel that Tyrrell was an important factor in securing that price. In saying this, I do not find that Salvatori in fact does feel a sense of obligation to Tyrrell, but there is certainly a strong possibility that he does, and that is enough under Zapata to preclude dismissal. Before moving on I note a few pieces of evidence that buttress my conclusion that there is a material question of fact regarding the SLC's independence. First, the SLC members appear to have reviewed the merits of plaintiffs' claims before the SLC was ever formed. In September 2007, plaintiffs' counsel sent a letter to iGov outlining many of the allegations that ultimately appeared in plaintiffs' complaint and requesting a meeting to begin resolving the dispute. The McLean Valuations were attached to the letter. In response, iGov's counsel sent a letter explaining that iGov disagreed with plaintiffs' allegations and would not meet until defendants and "iGov's new board members, John Vinter and Vincent Salvatori, had time to review the McLean Valuations." 64 Vinter and Salvatori both testified that they could not remember reviewing the McLean Valuations, but it is clear that the iGov audit committee, on which both men sit, reviewed the McLean Valuations on October 29, 2007. 65 When SLC members are simply exposed to or become familiar with a derivative suit before the SLC is formed this may not be enough to create a material question of fact as to the SLC's independence. But if evidence suggests that the SLC members prejudged the merits of the suit based on that prior exposure or familiarity, and then conducted the investigation with the object of putting together a report that demonstrates the suit has no merit, this will create a material question of fact as to the SLC's independence. In this case, that is what has occurred. Two similar pieces of evidence suggest that Vinter and Salvatori may not have conducted their investigation objectively after having considered plaintiffs' claims. First, Salvatori was asked in his deposition about the SLC's efforts to investigate the allegations in plaintiffs' complaint. Salvatori responded "I know we read it all over and I know we attacked it all." 66 Plaintiffs' counsel followed up with "[y]ou did what it all?" to which Salvatori answered "[a]ttacked it all." 67 Salvatori's counsel then repeated "[a]ttacked it all" after which Salvatori changed his answer to "[w]e considered it." 68 To my mind, the word "attack" in this context suggests something other than objectivity. But I readily admit that expressions can be misinterpreted and words can be inadvertently misused. In fact, if this were the only piece of evidence suggesting that the SLC might have engaged in a combative assault rather than an investigation I would be inclined to consider Salvatori's use of the verb "attack" as ambiguous.

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But the second piece of evidence has Vinter using the same verb--"attack"--in relation to the McLean Valuations. Vinter's notes from a June 26, 2009 meeting, at which SRR gave an update of its views of the $ 4.92 strike price, state as follows: McLean attack -forecast -low margin 1.3 --> 1.5 -marketability discount -fully diluted approach 69 As one can see, this appears to be a bullet-point summary of what is purportedly wrong with the McLean Valuations. Some of these criticisms of the McLean Valuations ended up in the SLC Report. In his deposition, Vinter stated his belief that he thought the word "attack" in the notes really said "attach." 70 But "attach" does not make any sense in the context of the note. Plaintiffs characterize Salvatori and Vinter's uses of the word "attack" as an indication that from the outset of the investigation the SLC was gathering information with the object of putting together a report that cast doubt on the merits of plaintiffs' claims, rather than objectively considering plaintiffs' claims. Given the SLC members' relationships to Tyrrell, their exposure to the merits of plaintiffs' suit well before the SLC was formed, 71 and the unsatisfactory scope of the investigation conducted (of which more will be said below), Salvatori and Vinter's use of the word "attack" does not help to fully convince me that the SLC was independent. In sum, the independence inquiry under Zapata is critically important if the SLC process is to remain a legitimate mechanism in our corporate law. 72 SLC members should be selected with the utmost care to ensure that they can, in both fact and appearance, carry out the extraordinary responsibility placed on them to determine the merits of the suit and the best interests of the corporation, acting as proxy for a disabled board. In this case, I am not satisfied that the independence prong of the Zapata standard has been met.

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